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Solutions for Homework ** Managerial Accounting 507 **

Winter 2009

CHAPTER 1
1-1 Management accounting measures, analyzes and reports financial and nonfinancial
information that helps managers make decisions to fulfill the goals of an organization. It focuses on
internal reporting and is not restricted by generally accepted accounting principles (GAAP).
Financial accounting focuses on reporting to external parties such as investors, government
agencies, and banks. It measures and records business transactions and provides financial statements
that are based on generally accepted accounting principles (GAAP).
Other differences include (1) management accounting emphasizes the future (not the past),
and (2) management accounting influences the behavior of managers and other employees (rather
than primarily reporting economic events).

1-2 Financial accounting is constrained by generally accepted accounting principles.


Management accounting is not restricted to these principles. The result is that:
 management accounting allows managers to charge interest on owners’ capital to help
judge a division’s performance, even though such a charge is not allowed under GAAP,
 management accounting can include assets or liabilities (such as “brand names” developed
internally) not recognized under GAAP, and
 management accounting can use asset or liability measurement rules (such as present
values or resale prices) not permitted under GAAP.

1-5 Supply chain describes the flow of goods, services, and information from the initial sources
of materials and services to the delivery of products to consumers, regardless of whether those
activities occur in the same organization or in other organizations.
Cost management is most effective when it integrates and coordinates activities across all
companies in the supply chain as well as across each business function in an individual company’s
value chain. Attempts are made to restructure all cost areas to be more cost-effective.

1-14 The Institute of Management Accountants (IMA) sets standards of ethical conduct for
management accountants in the following areas:
 Competence
 Confidentiality
 Integrity
 Credibility

Accounting 507 Managerial Accounting Winter 2009 1


1-29 (30–40 min.) Professional ethics and end-of-year actions.

1. The possible motivations for the snack foods division wanting to take end-of-year actions
include:
(a) Management incentives. Gourmet Foods may have a division bonus scheme based on
one-year reported division earnings. Efforts to front-end revenue into the current year or
transfer costs into the next year can increase this bonus.
(b) Promotion opportunities and job security. Top management of Gourmet Foods likely will
view those division managers that deliver high reported earnings growth rates as being
the best prospects for promotion. Division managers who deliver “unwelcome surprises”
may be viewed as less capable.
(c) Retain division autonomy. If top management of Gourmet Foods adopts a “management
by exception” approach, divisions that report sharp reductions in their earnings growth
rates may attract a sizable increase in top management supervision.

2. The “Standards of Ethical Conduct . . . ” require management accountants to


 Perform professional duties in accordance with relevant laws, regulations, and technical
standards.
 Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
 Communicate information fairly and objectively.

Several of the “end-of-year actions” clearly are in conflict with these requirements and should be
viewed as unacceptable by Taylor.
(b) The fiscal year-end should be closed on midnight of December 31. “Extending” the close
falsely reports next year’s sales as this year’s sales.
(c) Altering shipping dates is falsification of the accounting reports.
(f) Advertisements run in December should be charged to the current year. The advertising
agency is facilitating falsification of the accounting records.

The other “end-of-year actions” occur in many organizations and fall into the “gray” to “acceptable”
area. However, much depends on the circumstances surrounding each one, such as the following:
(a) If the independent contractor does not do maintenance work in December, there is no
transaction regarding maintenance to record. The responsibility for ensuring that
packaging equipment is well maintained is that of the plant manager. The division
controller probably can do little more than observe the absence of a December
maintenance charge.
(d) In many organizations, sales are heavily concentrated in the final weeks of the fiscal year-
end. If the double bonus is approved by the division marketing manager, the division
controller can do little more than observe the extra bonus paid in December.
(e) If TV spots are reduced in December, the advertising cost in December will be reduced.
There is no record falsification here.
(g) Much depends on the means of “persuading” carriers to accept the merchandise. For
example, if an under-the-table payment is involved, or if carriers are pressured to accept
merchandise, it is clearly unethical. If, however, the carrier receives no extra
consideration and willingly agrees to accept the assignment because it sees potential sales
opportunities in December, the transaction appears ethical.

Accounting 507 Managerial Accounting Winter 2009 2


Each of the (a), (d), (e), and (g) “end-of-year actions” may well disadvantage Gourmet Foods in the
long run. For example, lack of routine maintenance may lead to subsequent equipment failure. The
divisional controller is well advised to raise such issues in meetings with the division president.
However, if Gourmet Foods has a rigid set of line/staff distinctions, the division president is the one
who bears primary responsibility for justifying division actions to senior corporate officers.

3. If Taylor believes that Ryan wants her to engage in unethical behavior, she should first
directly raise her concerns with Ryan. If Ryan is unwilling to change his request, Taylor should
discuss her concerns with the Corporate Controller of Gourmet Foods. She could also initiate a
confidential discussion with an IMA Ethics Counselor, other impartial adviser, or her own attorney.
Taylor also may well ask for a transfer from the snack foods division if she perceives Ryan is
unwilling to listen to pressure brought by the Corporate Controller, CFO, or even President of
Gourmet Foods. In the extreme, she may want to resign if the corporate culture of Gourmet Foods is
to reward division managers who take “end-of-year actions” that Taylor views as unethical and
possibly illegal. It was precisely actions along the lines of (b), (c), and (f) that caused Betty Vinson,
an accountant at WorldCom to be indicted for falsifying WorldCom’s books and misleading
investors.

CHAPTER 2

2.4 Factors affecting the classification of a cost as direct or indirect include


 the materiality of the cost in question,
 available information-gathering technology,
 design of operations

2.10 Manufacturing companies typically have one or more of the following three types of
inventory:
1. Direct materials inventory. Direct materials in stock and awaiting use in the
manufacturing process.
2. Work-in-process inventory. Goods partially worked on but not yet completed. Also called
work in progress.
3. Finished goods inventory. Goods completed but not yet sold.

2-22 (15–20 min.) Variable costs and fixed costs.

1. Variable cost per ton of beach sand mined


Subcontractor $ 80 per ton
Government tax 50 per ton
Total $130 per ton

Fixed costs per month


0 to 100 tons of capacity per day = $150,000
101 to 200 tons of capacity per day = $300,000
201 to 300 tons of capacity per day = $450,000

Accounting 507 Managerial Accounting Winter 2009 3


2.
$975,000 $450,000

Costs
Total Variable Costs
$650,000 $300,000

Total Fixed
$325,000 $150,000

2,500 5,000 7,500 100 200 300


Tons Mined Tons of Capacity per Day

The concept of relevant range is potentially relevant for both graphs. However, the question does not
place restrictions on the unit variable costs. The relevant range for the total fixed costs is from 0 to
100 tons; 101 to 200 tons; 201 to 300 tons, and so on. Within these ranges, the total fixed costs do
not change in total.

3.
Tons Tons Fixed Unit Variable Total Unit
Mined Mined Cost per Ton Unit Cost per
per Day per Month Cost per Ton
Ton
(1) (2) = (1) × (3) = FC ÷ (2) (4) (5) = (3) +
25 (4)
(a) 180 4,500 $300,000 ÷ 4,500 = $130 $196.67
$66.67
(b) 220 5,500 $450,000 ÷ 5,500 = $130 $211.82
$81.82

The unit cost for 220 tons mined per day is $211.82, while for 180 tons it is only $196.67. This
difference is caused by the fixed cost increment from 101 to 200 tons being spread over an increment
of 80 tons, while the fixed cost increment from 201 to 300 tons is spread over an increment of only
20 tons.

Accounting 507 Managerial Accounting Winter 2009 4


2-23 (20 min.) Variable costs, fixed costs, relevant range.
1. Since the production capacity is 4,000 jaw breakers per month, the current annual relevant range
of output is 0 to 4,000 jaw breakers × 12 months = 0 to 48,000 jaw breakers.

2. Current annual fixed manufacturing costs within the relevant range are $1,000 × 12 = $12,000 for
rent and other overhead costs, plus $6,000 ÷ 10 = $600 for depreciation, totaling $12,600.
The variable costs, the materials, are 10 cents per jaw breaker, or $3,600 ($0.10 per jaw breaker ×
3,000 jaw breakers per month × 12 months) for the year.

3. If demand changes from 3,000 to 6,000 jaw breakers per month, or from 3,000 × 12 = 36,000 to
6,000 × 12 = 72,000 jaw breakers per year, Yumball will need a second machine. Assuming Yumball
buys a second machine identical to the first machine, it will increase capacity from 4,000 jaw
breakers per month to 8,000. The annual relevant range will be between 4,000 × 12 = 48,000 and
8,000 × 12 = 96,000 jaw breakers.
Assume the second machine costs $6,000 and is depreciated using straight-line depreciation over
10 years and zero residual value, just like the first machine. This will add $600 of depreciation per
year.
Fixed costs for next year will increase to $13,200, $12,600 from the current year + $600 (because
rent and other fixed overhead costs will remain the same at $12,000). That is, total fixed costs for
next year equal $600 (depreciation on first machine) + $600 (depreciation on second machine) +
$12,000 (rent and other fixed overhead costs).
The variable cost per jaw breaker next year will be 90% × $0.10 = $0.09. Total variable costs
equal $0.09 per jaw breaker × 72,000 jaw breakers = $6,480.

2-29 (20 min.) Flow of Inventoriable Costs.

(All numbers below are in millions).

1.
Direct materials inventory 8/1/2008 $ 90
Direct materials purchased 360
Direct materials available for production 450
Direct materials used 375
Direct materials inventory 8/31/2008 $ 75

2.
Total manufacturing overhead costs $ 480
Subtract: Variable manufacturing overhead costs (250)
Fixed manufacturing overhead costs for August $ 230

3.
Total manufacturing costs $ 1,600
Subtract: Direct materials used (from requirement 1) (375)
Total manufacturing overhead costs (480)
Direct manufacturing labor costs for August $ 745

Accounting 507 Managerial Accounting Winter 2009 5


4.
Work-in-process inventory 8/1/2008 $ 200
Total manufacturing costs 1,600
Work-in-process available for production 1,800
Subtract: Cost of goods manufactured (moved into FG) (1,650)
Work-in-process inventory 8/31/2008 $ 150

5.
Finished goods inventory 8/1/2008 $ 125
Cost of goods manufactured (moved from WIP) 1,650
Finished goods available for sale in August $ 1,775

6.
Finished goods available for sale in August (from requirement 5) $ 1,775
Subtract: Cost of goods sold (1,700)
Finished goods inventory 8/31/2008 $ 75

2-30 (20 min.) Computing cost of goods purchased and cost of goods sold.

(1) Marvin Department Store


Schedule of Cost of Goods Purchased
For the Year Ended December 31, 2008
(in thousands)

Purchases $155,000
Add transportation-in 7,000
162,000
Deduct:
Purchase return and allowances $4,000
Purchase discounts 6,000 10,000
Cost of goods purchased $152,000

(2) Marvin Department Store


Schedule of Cost of Goods Sold
For the Year Ended December 31, 2008
(in thousands)

Beginning merchandise inventory 1/1/2008 $ 27,000


Cost of goods purchased (above) 152,000
Cost of goods available for sale 179,000
Ending merchandise inventory 12/31/2008 34,000
Cost of goods sold $145,000

Accounting 507 Managerial Accounting Winter 2009 6


2-37 (30–40 min.) Fire loss, computing inventory costs.

1. Finished goods inventory, 2/26/2009 = $50,000


2. Work-in-process inventory, 2/26/2009 = $28,000
3. Direct materials inventory, 2/26/2009 = $62,000

This problem is not as easy as it first appears. These answers are obtained by working from the
known figures to the unknowns in the schedule below. The basic relationships between categories of
costs are:

Prime costs (given) = $294,000


Direct materials used = $294,000 – Direct manufacturing labor costs
= $294,000 – $180,000 = $114,000
Conversion costs = Direct manufacturing labor costs ÷ 0.6
$180,000 ÷ 0.6 = $300,000
Indirect manuf. costs = $300,000 – $180,000 = $120,000 (or 0.40  $300,000)

Schedule of Computations
Direct materials, 1/1/2009 $ 16,000
Direct materials purchased 160,000
Direct materials available for use 176,000
Direct materials, 2/26/2009 3= 62,000
Direct materials used ($294,000 – $180,000) 114,000
Direct manufacturing labor costs 180,000
Prime costs 294,000
Indirect manufacturing costs 120,000
Manufacturing costs incurred during the current period 414,000
Add work in process, 1/1/2009 34,000
Manufacturing costs to account for 448,000
Deduct work in process, 2/26/2009 2= 28,000
Cost of goods manufactured 420,000
Add finished goods, 1/1/2009 30,000
Cost of goods available for sale (given) 450,000
Deduct finished goods, 2/26/2009 1= 50,000
Cost of goods sold (80% of $500,000) $400,000

Some instructors may wish to place the key amounts in a Work in Process T-account. This problem
can be used to introduce students to the flow of costs through the general ledger (amounts in
thousands):
Cost of
Work in Process Finished Goods Goods Sold
BI 34 BI 30
DM used 114 COGM 420 -------> 420 COGS 400 ---->400
DL 180
OH 120 Available
To account for 448 for sale 450

EI 28 EI 50

Accounting 507 Managerial Accounting Winter 2009 7


CHAPTER 3
3-8 An increase in the income tax rate does not affect the breakeven point. Operating income at
the breakeven point is zero, and no income taxes are paid at this point.

3-16 (10 min.) CVP computations.

Variable Fixed Total Operating Contribution Contribution


Revenues Costs Costs Costs Income Margin Margin %
a. $2,000 $ 500 $300 $ 800 $1,200 $1,500 75.0%
b. 2,000 1,500 300 1,800 200 500 25.0%
c. 1,000 700 300 1,000 0 300 30.0%
d. 1,500 900 300 1,200 300 600 40.0%

3-17 (10–15 min.) CVP computations.

1a. Sales ($30 per unit × 200,000 units) $6,000,000


Variable costs ($25 per unit × 200,000 units) 5,000,000
Contribution margin $1,000,000

1b. Contribution margin (from above) $1,000,000


Fixed costs 800,000
Operating income $ 200,000

2a. Sales (from above) $6,000,000


Variable costs ($16 per unit × 200,000 units) 3,200,000
Contribution margin $2,800,000

2b. Contribution margin $2,800,000


Fixed costs 2,400,000
Operating income $ 400,000

3. Operating income is expected to increase by $200,000 if Ms. Schoenen’s proposal is accepted.


The management would consider other factors before making the final decision. It is likely
that product quality would improve as a result of using state of the art equipment. Due to increased
automation, probably many workers will have to be laid off. Patel’s management will have to
consider the impact of such an action on employee morale. In addition, the proposal increases the
company’s fixed costs dramatically. This will increase the company’s operating leverage and risk.

3-23 (30 min.) CVP analysis, sensitivity analysis.

1. SP = $30.00  (1 – 0.30 margin to bookstore)


= $30.00  0.70 = $21.00

VCU = $ 4.00 variable production and marketing cost


3.15 variable author royalty cost (0.15  $21.00)
$ 7.15

Accounting 507 Managerial Accounting Winter 2009 8


CMU = $21.00 – $7.15 = $13.85 per copy
FC = $ 500,000 fixed production and marketing cost
3,000,000 up-front payment to Washington
$3,500,000

Solution Exhibit 3-23A shows the PV graph.

SOLUTION EXHIBIT 3-23A


PV Graph for Media Publishers

$4,000 FC = $3,500,000
CMU = $13.85 per book sold

3,000

’s) 2,000
00
(0
e 1,000
m
co
in 0 Units sold
g 100,000 200,000 300,000 400,000 500,000
in
rat -1,000 252,708 units
pe
O
-2,000

-3,000
$3.5 million

-4,000

Accounting 507 Managerial Accounting Winter 2009 9


2a.
FC
=
CMU
$3,500,000
=
$13.85

= 252,708 copies sold (rounded up)

FC  OI
2b. Target OI =
CMU

$3,500,000  $2,000,000
=
$13.85
$5,500,000
=
$13.85
= 397,112 copies sold (rounded up)
3a. Decreasing the normal bookstore margin to 20% of the listed bookstore price of $30 has the
following effects:

SP = $30.00  (1 – 0.20)
= $30.00  0.80 = $24.00
VCU = $ 4.00 variable production and marketing cost
+ 3.60 variable author royalty cost (0.15  $24.00)
$ 7.60

CMU = $24.00 – $7.60 = $16.40 per copy

FC
=
CMU
$3,500,000
=
$16.40
= 213,415 copies sold (rounded up)

The breakeven point decreases from 252,708 copies in requirement 2 to 213,415 copies.

3b. Increasing the listed bookstore price to $40 while keeping the bookstore margin at 30% has
the following effects:

SP = $40.00  (1 – 0.30)
= $40.00  0.70 = $28.00
VCU =$ 4.00 variable production and marketing cost
+ 4.20 variable author royalty cost (0.15  $28.00)
$ 8.20

CMU= $28.00 – $8.20 = $19.80 per copy

Accounting 507 Managerial Accounting Winter 2009 10


$3,500,000
=
$19.80
= 176,768 copies sold (rounded up)

The breakeven point decreases from 252,708 copies in requirement 2 to 176,768 copies.

3c. The answers to requirements 3a and 3b decrease the breakeven point relative to that in
requirement 2 because in each case fixed costs remain the same at $3,500,000 while the contribution
margin per unit increases.

3-24 (10 min.) CVP analysis, margin of safety.


Fixed costs
1. Breakeven point revenues = Contribution margin percentage
$600,000
Contribution margin percentage = = 0.40 or
$1,500,000
40%
Selling price  Variable cost per unit
2. Contribution margin percentage = Selling price
SP  $15
0.40 =
SP
0.40 SP = SP – $15
0.60 SP = $15
SP = $25
3. Breakeven sales in units = Revenues ÷ Selling price = $1,500,000 ÷ $25 = 60,000 units
Margin of safety in units = sales in units – Breakeven sales in units
= 80,000 – 60,000 = 20,000 units

Revenues, 80,000 units  $25 $2,000,000


Breakeven revenues 1,500,000
Margin of safety $ 500,000

Accounting 507 Managerial Accounting Winter 2009 11


3-25 (25 min.) Operating leverage.

1a. Let Q denote the quantity of carpets sold

Breakeven point under Option 1


$500Q  $350Q = $5,000
$150Q = $5,000
Q = $5,000  $150 = 34 carpets (rounded up)

1b. Breakeven point under Option 2


$500Q  $350Q  (0.10  $500Q) = 0
100Q = 0
Q = 0

2. Operating income under Option 1 = $150Q  $5,000


Operating income under Option 2 = $100Q

Find Q such that $150Q  $5,000 = $100Q


$50Q = $5,000
Q = $5,000  $50 = 100 carpets
Revenues = $500 × 100 carpets = $50,000
For Q = 100 carpets, operating income under both Option 1 and Option 2 = $10,000

For Q > 100, say, 101 carpets,


Option 1 gives operating income = ($150  101)  $5,000 = $10,150
Option 2 gives operating income = $100  101 = $10,100
So Color Rugs will prefer Option 1.

For Q < 100, say, 99 carpets,


Option 1 gives operating income = ($150  99)  $5,000 = $9,850
Option 2 gives operating income = $100  99 = $9,900
So Color Rugs will prefer Option 2.

Contribution margin
3. Degree of operating leverage = Operating income
$150  100
Under Option 1, degree of operating leverage = $10,000 = 1.5
$100  100
Under Option 2, degree of operating leverage = $10,000 = 1.0

4. The calculations in requirement 3 indicate that when sales are 100 units, a percentage change
in sales and contribution margin will result in 1.5 times that percentage change in operating income
for Option 1, but the same percentage change in operating income for Option 2. The degree of
operating leverage at a given level of sales helps managers calculate the effect of fluctuations in
sales on operating incomes.

3-35 (20–25 min.) CVP analysis.

Accounting 507 Managerial Accounting Winter 2009 12


1. Selling price
$16.00
Variable costs per unit:
Purchase price $10.00
Shipping and handling 2.00
12.00
Contribution margin per unit (CMU) $ 4.00

Fixed costs $600,000


Breakeven point in units = Contr. margin per unit = = 150,000
$4.00
units
Margin of safety (units) = 200,000 – 150,000 = 50,000 units

2. Since Galaxy is operating above the breakeven point, any incremental


contribution margin will increase operating income dollar for dollar.

Increase in units sales = 10% × 200,000 = 20,000


Incremental contribution margin = $4 × 20,000 = $80,000

Therefore, the increase in operating income will be equal to $80,000.


Galaxy’s operating income in 2008 would be $200,000 + $80,000 = $280,000.

3. Selling price $16.00


Variable costs:
Purchase price $10 × 130% $13.00
Shipping and handling 2.00
15.00
Contribution margin per unit
$ 1.00

FC  TOI $600,000  $200,000


Target sales in units = = = 800,000 units
CMU $1

Target sales in dollars = $16 × 800,000 = $12,800,000

3-47 (20 min.) Gross margin and contribution margin.


1. Ticket sales ($20 �500 attendees) $10,000
Variable cost of dinner ($10a �500 attendees)$5,000
Variable invitations and paperwork ($1b �500) 500 5,500
Contribution margin 4,500
Fixed cost of dinner 6,000
Fixed cost of invitations and paperwork 2,500 8,500
Operating profit (loss) $ (4,000)
a
$5,000/500 attendees = $10/attendee
b
$500/500 attendees = $1/attendee

Accounting 507 Managerial Accounting Winter 2009 13


2. Ticket sales ($20 �1,000 attendees) $20,000
Variable cost of dinner ($10 �1,000 attendees) $10,000
Variable invitations and paperwork ($1 �1,000) 1,000 11,000
Contribution margin 9,000
Fixed cost of dinner 6,000
Fixed cost of invitations and paperwork 2,500 8,500
Operating profit (loss) $ 500

3-48 (30 min.) Ethics, CVP analysis.

Revenues  Variable costs


1. Contribution margin percentage =
Revenues
$5,000,000  $3,000,000
= $5,000,000
$2,000,000
= $5,000,000
= 40%
Fixed costs
Breakeven revenues = Contribution margin percentage
$2,160,000
= = $5,400,000
0.40

2. If variable costs are 52% of revenues, contribution margin percentage equals 48% (100% 
52%)

Fixed costs
Breakeven revenues = Contribution margin percentage
$2,160,000
= = $4,500,000
0.48

3. Revenues $5,000,000
Variable costs (0.52  $5,000,000) 2,600,000
Fixed costs 2,160,000
Operating income $ 240,000

4. Incorrect reporting of environmental costs with the goal of continuing operations is unethical.
In assessing the situation, the specific “Standards of Ethical Conduct for Management Accountants”
(described in Exhibit 1-7) that the management accountant should consider are listed below.

Competence
Clear reports using relevant and reliable information should be prepared. Preparing reports on the
basis of incorrect environmental costs to make the company’s performance look better than it is
violates competence standards. It is unethical for Bush not to report environmental costs to make the
plant’s performance look good.

Integrity
The management accountant has a responsibility to avoid actual or apparent conflicts of interest and
advise all appropriate parties of any potential conflict. Bush may be tempted to report lower

Accounting 507 Managerial Accounting Winter 2009 14


environmental costs to please Lemond and Woodall and save the jobs of his colleagues. This action,
however, violates the responsibility for integrity. The Standards of Ethical Conduct require the
management accountant to communicate favorable as well as unfavorable information.

Credibility
The management accountant’s Standards of Ethical Conduct require that information should be
fairly and objectively communicated and that all relevant information should be disclosed. From a
management accountant’s standpoint, underreporting environmental costs to make performance look
good would violate the standard of objectivity.

Bush should indicate to Lemond that estimates of environmental costs and liabilities should be
included in the analysis. If Lemond still insists on modifying the numbers and reporting lower
environmental costs, Bush should raise the matter with one of Lemond’s superiors. If after taking all
these steps, there is continued pressure to understate environmental costs, Bush should consider
resigning from the company and not engage in unethical behavior.

CHAPTER 10
10-1 The two assumptions are
1. Variations in the level of a single activity (the cost driver) explain the variations in the related
total costs.
2. Cost behavior is approximated by a linear cost function within the relevant range. A linear
cost function is a cost function where, within the relevant range, the graph of total costs
versus the level of a single activity forms a straight line.
10-17 (15 min.) Identifying variable-, fixed-, and mixed-cost functions.

1. See Solution Exhibit 10-17.

2. Contract 1: y = $50
Contract 2: y = $30 + $0.20X
Contract 3: y = $1X
where X is the number of miles traveled in the day.

3. Contract Cost Function


1 Fixed
2 Mixed
3 Variable

SOLUTION EXHIBIT 10-17


Plots of Car Rental Contracts Offered by Pacific Corp.

Accounting 507 Managerial Accounting Winter 2009 15


10-18 (20 min.) Various cost-behavior patterns.
1. K
2. B
3. G
4. J Note that A is incorrect because, although the cost per pound eventually equals a
constant at $9.20, the total dollars of cost increases linearly from that point
onward.
5. I The total costs will be the same regardless of the volume level.
6. L
7. F This is a classic step-cost function.
8. K
9. C

10-19 (30 min.) Matching graphs with descriptions of cost and revenue behavior.

a. (1)
b. (6) A step-cost function.
c. (9)
d. (2)
e. (8)
f. (10) It is data plotted on a scatter diagram, showing a linear variable cost function with
constant variance of residuals. The constant variance of residuals implies that
there is a uniform dispersion of the data points about the regression line.
g. (3)
h. (8)

10-20 (15 min.) Account analysis method.

1. Variable costs:
Car wash labor $260,000
Soap, cloth, and supplies 42,000
Water 38,000
Electric power to move conveyor belt 72,000
Total variable costs $412,000
Fixed costs:
Depreciation $ 64,000
Salaries 46,000
Total fixed costs $110,000
Some costs are classified as variable because the total costs in these categories change in proportion
to the number of cars washed in Lorenzo’s operation. Some costs are classified as fixed because the
total costs in these categories do not vary with the number of cars washed. If the conveyor belt
moves regardless of the number of cars on it, the electricity costs to power the conveyor belt would
be a fixed cost.

$412,000
2. Variable costs per car = = $5.15 per car
80,000
Total costs estimated for 90,000 cars = $110,000 + ($5.15 × 90,000) = $573,500

Accounting 507 Managerial Accounting Winter 2009 16


10-23 (15–20 min.) Estimating a cost function, high-low method.

1. The key point to note is that the problem provides high-low values of X (annual round trips
made by a helicopter) and Y �X (the operating cost per round trip). We first need to calculate the
annual operating cost Y (as in column (3) below), and then use those values to estimate the function
using the high-low method.

Cost Driver: Operating Annual


Annual Round- Cost per Operating
Trips (X) Round-Trip Cost (Y)
(1) (2) (3) = (1) �(2)
Highest observation of cost driver 2,000 $300 $600,000
Lowest observation of cost driver 1,000 $350 $350,000
Difference 1,000 $250,000

Slope coefficient = $250,000 �1,000 = $250 per round-trip


Constant = $600,000 – ($250 �2,000) = $100,000

The estimated relationship is Y = $100,000 + $250 X; where Y is the annual operating cost of a
helicopter and X represents the number of round trips it makes annually.

2. The constant a (estimated as $100,000) represents the fixed costs of operating a helicopter,
irrespective of the number of round trips it makes. This would include items such as insurance,
registration, depreciation on the aircraft, and any fixed component of pilot and crew salaries. The
coefficient b (estimated as $250 per round-trip) represents the variable cost of each round trip—costs
that are incurred only when a helicopter actually flies a round trip. The coefficient b may include
costs such as landing fees, fuel, refreshments, baggage handling, and any regulatory fees paid on a
per-flight basis.

3. If each helicopter is, on average, expected to make 1,200 round trips a year, we can use the
estimated relationship to calculate the expected annual operating cost per helicopter:

Y = $100,000 + $250 X
X = 1,200
Y = $100,000 + $250 �1,200 = $100,000 + $300,000 = $400,000

With 10 helicopters in its fleet, Reisen’s estimated operating budget is 10 �$400,000 = $4,000,000.

Accounting 507 Managerial Accounting Winter 2009 17


10-39 (30min.) Multiple regression (continuation of 10-38).

1. Solution Exhibit 10-39 presents the regression output for setup costs using both number of setups
and number of setup-hours as independent variables (cost drivers).

SOLUTION EXHIBIT 10-39


Regression Output for Multiple Regression for Setup Costs Using Both Number of Setups and
Number of Setup-Hours as Independent Variables (Cost Drivers)

2.
Economic A positive relationship between setup costs and each of the independent
plausibility variables (number of setups and number of setup-hours)
is economically plausible.

Goodness of fit r2 = 86%, Adjusted r2 = 81%


Standard error of regression =$14,392
Excellent goodness of fit.

Significance of The t-value of 0.46 for number of setups is not significant at the 0.05 level.
Independent The t-value of 4.68 for number of setup-hours is significant at the 0.05
Variables level.

Specification Assuming linearity, constant variance, and normality of residuals, the


analysis of Durbin-Watson statistic of 1.36 suggests the residuals are independent.
estimation However, we must be cautious when drawing inferences from only 9
assumptions observations.

Accounting 507 Managerial Accounting Winter 2009 18


3. Multicollinearity is an issue that can arise with multiple regression but not simple regression
analysis. Multicollinearity means that the independent variables are highly correlated.

The correlation feature in Excel’s Data Analysis reveals a coefficient of correlation of


0.56 between number of setups and number of setup-hours. Since the correlation is less than
0.70, the multiple regression does not suffer from multicollinearity problems.

4. The simple regression model using the number of setup-hours as the independent variable
achieves a comparable r2 to the multiple regression model. However, the multiple regression
model includes an insignificant independent variable, number of setups. Adding this variable
does not improve Williams’ ability to better estimate setup costs. Bebe should use the simple
regression model with number of setup-hours as the independent variable to estimate costs.

CHAPTER 4
4.16 (10 min) Job order costing, process costing.

a.Job costing l. Job costing


b. Process costing m. Process costing
c.Job costing n. Job costing
d. Process costing o. Job costing
e.Job costing p. Job costing
f. Process costing q. Job costing
g. Job costing r. Process costing
h. Job costing (but some process costing) s. Job costing
i. Process costing t. Process costing
j. Process costing u. Job costing
k. Job costing

Accounting 507 Managerial Accounting Winter 2009 19


4-21 (2025 min.) Job costing, consulting firm.

1. Budgeted indirect-cost rate = $13,000,000 ÷ $5,000,000 = 260% of professional labor costs

INDIRECT
COST
POOL
 Client
Consulting
Consulting
Support
Support
Support

COST
ALLOCATION
BASE
 Professional
Professional
Labor
LaborCosts
Costs


COST OBJECT:
Indirect Costs
JOB FOR
CONSULTING Direct Costs
CLIENT

DIRECT
COSTS  Professional
Labor

2. At the budgeted revenues of $20,000,000, Taylor’s operating income of $2,000,000 equals


10% of revenues.

Markup rate = $20,000,000 ÷ $5,000,000 = 400% of direct professional labor costs

3. Budgeted costs
Direct costs:
Director, $200  3 $ 600
Partner, $100  16 1,600
Associate, $50  40 2,000
Assistant, $30  160 4,800 $ 9,000
Indirect costs:
Consulting support, 260%  $9,000 23,400
Total costs $32,400
As calculated in requirement 2, the bid price to earn a 10% income-to-revenue margin is 400% of
direct professional costs. Therefore, Taylor should bid 4  $9,000 = $36,000 for the Red Rooster
job.
Bid price to earn target operating income-to-revenue margin of 10% can also be
calculated as follows:

Let R = revenue to earn target income


R – 0.10R = $32,400
0.90R = $32,400
R = $32,400 ÷ 0.90 = $36,000
Accounting 507 Managerial Accounting Winter 2009 20
or, Direct costs $ 9,000
Indirect costs 23,400
Operating income 3,600
Bid price $36,000

4-33 (25–30 min.) Service industry, job costing, two direct- and indirect-cost categories,
law firm (continuation of 4-32).

Although not required, the following overview diagram is helpful to understand Keating’s job-
costing system.

INDIRECT
COST
POOL
 General
Support
Secretarial
Support

COST
ALLOCATION
BASE
 Professional
Labor-Hours
Partner
Labor-Hours


COST OBJECT:
Indirect Costs
JOB FOR
CLIENT Direct Costs

DIRECT
COST } Professional
Professional
Partner Labor Associate Labor

1. Professional Professional
Partner Labor Associate Labor
Budgeted compensation per professional $ 200,000 $80,000
Divided by budgeted hours of billable
time per professional ÷1,600 ÷1,600
Budgeted direct-cost rate $125 per hour* $50 per hour†

Total budgeted partner labor costs


*Can also be calculated as Total budgeted partner labor - hours =
$200,000  5 $1,000,000
1,600  5
= 8, 000
= $125

Total budgeted associate labor costs
Can also be calculated as Total budgeted associate labor - hours =
$80,000  20 $1,600,000
1,600  20
= 32,000
= $ 50

2. General Secretarial
Support Support
Budgeted total costs $1,800,000 $400,000
Divided by budgeted quantity of allocation base ÷ 40,000 hours ÷ 8,000 hours
Budgeted indirect cost rate $45 per hour $50 per hour

Accounting 507 Managerial Accounting Winter 2009 21


3. Richardson Punch
Direct costs:
Professional partners, $125  60; $125  30 $7,500 $3,750
Professional associates, $50  40; $50  120 2,000 6,000
Direct costs $ 9,500 $ 9,750
Indirect costs:
General support, $45  100; $45  150 4,500 6,750
Secretarial support, $50  60; $50  30 3,000 1,500
Indirect costs 7,500 8,250
Total costs $17,000 $18,000

4. Richardson Punch
Single direct - Single indirect
(from Problem 4-32) $12,000 $18,000
Multiple direct – Multiple indirect
(from requirement 3 of Problem 4-33) 17,000 18,000

Difference $ 5,000 $ 0
undercosted no change

The Richardson and Punch jobs differ in their use of resources. The Richardson job has a
mix of 60% partners and 40% associates, while Punch has a mix of 20% partners and 80%
associates. Thus, the Richardson job is a relatively high user of the more costly partner-related
resources (both direct partner costs and indirect partner secretarial support). The refined-costing
system in Problem 4-32 increases the reported cost in Problem 4-32 for the Richardson job by
41.7% (from $12,000 to $17,000).

Accounting 507 Managerial Accounting Winter 2009 22


4-34 (2025 min.) Proration of overhead.
1. Budgeted manufacturing overhead rate is $4,800,000 ÷ 80,000 hours = $60 per machine-hour.

Manufacturing overhead Manufacturing overhead Manufacturing overhead


2. underallocated = incurred – allocated
= $4,900,000 – $4,500,000*
= $400,000
*$60  75,000 actual machine-hours = $4,500,000
a. Write-off to Cost of Goods Sold
Write-off
of $400,000
Account Underallocated Account
Balance Manufacturing Balance
Account (Before Proration) Overhead (After Proration)
(1) (2) (3) (4) = (2) + (3)

Work in Process $ 750,000 $ 0 $ 750,000


Finished Goods 1,250,000 0 1,250,000
Cost of Goods Sold 8,000,000 400,000 8,400,000
Total $10,000,000 $400,000 $10,400,000

b. Proration based on ending balances (before proration) in Work in Process, Finished


Goods and Cost of Goods Sold.
Proration of $400,000
Underallocated Account
Account Balance Manufacturing Balance
Account (Before Proration) Overhead (After Proration)
(1) (2) (3) (4) = (2) + (3)
Work in Process $ 750,000 ( 7.5%) 0.075  $400,000 = $ 30,000 $ 780,000
Finished Goods 1,250,000 (12.5%) 0.125  $400,000 = 50,000 1,300,000
Cost of Goods Sold 8,000,000 (80.0%) 0.800  $400,000 = 320,000 8,320,000
Total $10,000,000 100.0% $400,000 $10,400,000

c. Proration based on the allocated overhead amount (before proration) in the


ending balances of Work in Process, Finished Goods, and Cost of Goods Sold.
Account Allocated Overhead Account
Balance Included in Proration of $400,000 Balance
(Before the Account Balance Underallocated (After
Account Proration) (Before Proration) Manufacturing Overhead Proration)
(1) (2) (3) (4) (5) (6) = (2) + (5)
Work in Process $ 750,000 $ 240,000a ( 5.33%) 0.0533  $400,000 = $ 21,320 $ 771,320
Finished Goods 1,250,000 660,000b (14.67%) 0.1467  $400,000 = 58,680 1,308,680
8,320,0
Cost of Goods Sold 8,000,000 3,600,000 (80.00%) 0.8000  $400,000 = 320,000
c
00
Total $10,000,000 $4,500,000 100.00% $400,000 $10,400,000

a
$60  4,000 machine-hours; b$60  11,000 machine-hours; c$60  60,000 machine-hours
Accounting 507 Managerial Accounting Winter 2009 23
3. Alternative (c) is theoretically preferred over (a) and (b). Alternative (c) yields the same
ending balances in work in process, finished goods, and cost of goods sold that would have been
reported had actual indirect cost rates been used.
Chapter 4 also discusses an adjusted allocation rate approach that results in the same
ending balances as does alternative (c). This approach operates via a restatement of the indirect
costs allocated to all the individual jobs worked on during the year using the actual indirect cost
rate.

4-35 (15 min.) Normal costing, overhead allocation, working backward.

1a. Manufacturing overhead allocated = 200% × Direct manufacturing labor cost

$3,600,000 = 2 × Direct manufacturing labor cost

$3,600,000
Direct manufacturing labor cost = = $1,800,000
2

Total manufacturing Direct material Direct manufacturing Manufacturing


b. cost = used + labor cost + overhead allocated

$8,000,000 = Direct material used + $1,800,000 + $3,600,000

Direct material used = $2,600,000

Work in Process Work in Process


2. 1/1/2009 + Total manufacturing cost = Cost of goods manufactured + 12/31/2009

Denote Work-in-process on 12/31/2009 by X

$320,000 + $8,000,000 = $7,920,000 + X

X = $400,000

Work-in-process inventory, 12/31/09 = $400,000.

Accounting 507 Managerial Accounting Winter 2009 24


CHAPTER 17

17-19 (15 min.) Weighted-average method, equivalent units.

Under the weighted-average method, equivalent units are calculated as the equivalent units of
work done to date. Solution Exhibit 17-19 shows equivalent units of work done to date for the
Assembly Division of Fenton Watches, Inc., for direct materials and conversion costs.

SOLUTION EXHIBIT 17-19


Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units;
Weighted-Average Method of Process Costing, Assembly Division of Fenton Watches, Inc., for
May 2009.
(Step 2)
(Step 1) Equivalent Units
Physical Direct Conversion
Flow of Production Units Materials Costs
Work in process beginning (given) 80
Started during current period (given) 500
To account for 580
Completed and transferred out during current period 460 460 460
Work in process, ending* (120  60%; 120  30%) 120 72 36
Accounted for 580 ___ ___
Work done to date 532 496

*Degree of completion in this department: direct materials, 60%; conversion costs, 30%.

Accounting 507 Managerial Accounting Winter 2009 25


17-20 (20 min.) Weighted-average method, assigning costs (continuation of 17-19).

Solution Exhibit 17-20 summarizes total costs to account for, calculates cost per equivalent unit
of work done to date in the Assembly Division of Fenton Watches, Inc., and assigns costs to units
completed and to units in ending work-in-process inventory.

SOLUTION EXHIBIT 17-20


Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and
Assign Total Costs to Units Completed and to Units in Ending Work in Process;
Weighted-Average Method of Process Costing, Assembly Division of Fenton Watches, Inc., for
May 2009.

Total
Production Direct Conversion
Costs Materials Costs
(Step 3) Work in process, beginning (given) $ 584,400 $ 493,360 $ 91,040
Costs added in current period (given) 4,612,000 3,220,000 1,392,000
Total costs to account for $5,196,400 $3,713,360 $1,483,040

(Step 4) Costs incurred to date $3,713,360 $1,483,040


Divide by equivalent units of work
done to date (Solution Exhibit 17-19)  532  496
Cost per equivalent unit of work done $ 6,980 $ 2,990
to date

(Step 5) Assignment of costs:


Completed and transferred out (460 $4,586,200 (460*  $6,980) + (460*  $2,990)
units)
Work in process, ending (120 units) (72†  $6,980) + (36† 
610,200 $2,990)
Total costs accounted for $3,713,360 +
$5,196,400 $1,483,040
*
Equivalent units completed and transferred out from Solution Exhibit 17-19, Step 2.

Equivalent units in work in process, ending from Solution Exhibit 17-19, Step 2.

Accounting 507 Managerial Accounting Winter 2009 26


17-35 (25 min.) Weighted-average method.

Solution Exhibit 17-35A shows equivalent units of work done to date of:

Direct materials 625 equivalent units


Conversion costs 525 equivalent units

Note that direct materials are added when the Assembly Department process is 10%
complete. Both the beginning and ending work in process are more than 10% complete and
hence are 100% complete with respect to direct materials.
Solution Exhibit 17-35B summarizes the total Assembly Department costs for April
2009, calculates cost per equivalent unit of work done to date for direct materials and conversion
costs, and assigns these costs to units completed (and transferred out), and to units in ending
work in process using the weighted-average method.

SOLUTION EXHIBIT 17-35A


Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units;
Weighted-Average Method of Process Costing, Assembly Department of Porter Handcraft for
April 2009.

(Step 1)(Step 2)
Equivalent Units
Physical Direct Conversion
Flow of Production Units Materials Costs
Work in process, beginning (given) 75
Started during current period (given) 550
To account for 625
Completed and transferred out
during current period 500 500 500
Work in process, ending* (given) 125
125  100%; 125  20% 125 25
Accounted for 625
Work done to date 625 525
*
Degree of completion in this department: direct materials, 100%; conversion costs, 20%.

Accounting 507 Managerial Accounting Winter 2009 27


SOLUTION EXHIBIT 17-35B
Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and
Assign Total Costs to Units Completed and to Units in Ending Work in Process;
Weighted-Average Method of Process Costing, Assembly Department of Porter, April 2009.

Total
Production Direct Conversion
Costs Materials Costs
(Step 3) Work in process, beginning (given) $ 1,910 $ 1,775 $ 135
Costs added in current period (given) 28,490 17,600 10,890
Total costs to account for $30,400 $19,375 $11,025

(Step 4) Costs incurred to date $19,375 $11,025


Divide by equivalent units of work done to
date (Solution Exhibit 17-35A)  625  525
Cost per equivalent unit of work done to date $ 31 $ 21

(Step 5) Assignment of costs:


Completed and transferred out (500 units) $26,000 (500*  $31) + (500*  $21)
Work in process, ending (125 units) 4,400 (125†  $31) + (25†  $21)
Total costs accounted for $30,400 $19,375 + $11,025
*
Equivalent units completed and transferred out from Solution Exhibit 17-35A, Step 2.

Equivalent units in ending work in process from Solution Exhibit 17-35A, Step 2.

17.38 (30 min.) Transferred-in costs, weighted average.

1. Solution Exhibit 17-38A computes the equivalent units of work done to date in the
Binding Department for transferred-in costs, direct materials, and conversion costs.
Solution Exhibit 17-38B summarizes total Binding Department costs for April 2009,
calculates the cost per equivalent unit of work done to date in the Binding Department for
transferred-in costs, direct materials, and conversion costs, and assigns these costs to units
completed and transferred out and to units in ending work in process using the weighted-average
method.

2. Journal entries:
a. Work in Process–– Binding Department 144,000
Work in Process––Printing Department 144,000
Cost of goods completed and transferred out
during April from the Printing Department
to the Binding Department
b. Finished Goods 249,012
Work in Process–– Binding Department 249,012
Cost of goods completed and transferred out
during April from the Binding Department
to Finished Goods inventory

Accounting 507 Managerial Accounting Winter 2009 28


SOLUTION EXHIBIT 17-38A
Steps 1 and 2: Summarize Output in Physical Units and Compute Output in Equivalent Units;
Weighted-Average Method of Process Costing,
Binding Department of Publish, Inc. for April 2009.

(Step 1) (Step 2)
Equivalent Units
Physical Transferred- Direct Conversion
Flow of Production Units in Costs Materials Costs
Work in process, beginning (given) 900
Transferred-in during current period (given) 2,700
To account for 3,600
Completed and transferred out during current period: 3,000 3,000 3,000 3,000
Work in process, endinga (given) 600
(600 �100%; 600 �0%; 600 �60%) 600 0 360
Accounted for 3,600
Work done to date 3,600 3,000 3,360
a
Degree of completion in this department: transferred-in costs, 100%; direct materials, 0%;
conversion costs, 60%.

Accounting 507 Managerial Accounting Winter 2009 29


SOLUTION EXHIBIT 17-38B
Steps 3, 4, and 5: Summarize Total Costs to Account For, Compute Cost per Equivalent Unit, and Assign Total Costs to
Units Completed and to Units in Ending Work in Process;
Weighted-Average Method of Process Costing,
Binding Department of Publish, Inc. for April 2009.

Total
Production Transferred-in Direct Conversion
Costs Costs Materials Costs
(Step 3) Work in process, beginning (given) $ 47,775 $ 32,775 $ 0 $15,000
Costs added in current period (given) 239,700 144,000 26,700 69,000
Total costs to account for $287,475 $176,775 $26,700 $84,000

(Step 4) Costs incurred to date $176,775 $26,700 $84,000


Divide by equivalent units of work done to date
(Solution Exhibit 17-38A) ÷ 3,600 ÷ 3,000 ÷ 3,360
Cost per equivalent unit of work done to date $ 49.104 $ 8.90 $ 25

(Step 5) Assignment of costs:


(3,000a × $49.104) + (3,000a × $8.90) +
Completed and transferred out (3,000 units) $249,012 (3,000a × $25)
(600b × $49.104) + (0b × $8.90) + (360b
Work in process, ending (600 units): 38,463 × $25)
$176,77
Total costs accounted for $287,475 5 + $26,700 + $84,000
a
Equivalent units completed and transferred out from Sol. Exhibit 17-38A, step 2.
b
Equivalent units in ending work in process from Sol. Exhibit 17-38A, step 2.

Accounting 507 Managerial Accounting Winter 2009 30


CHAPTER 15

15-9 The stand-alone cost-allocation method uses information pertaining to each user of a cost
object as a separate entity to determine the cost-allocation weights.
The incremental cost-allocation method ranks the individual users of a cost object in the
order of users most responsible for the common costs and then uses this ranking to allocate costs
among those users. The first-ranked user of the cost object is the primary user and is allocated
costs up to the costs of the primary user as a stand-alone user. The second-ranked user is the first
incremental user and is allocated the additional cost that arises from two users instead of only the
primary user. The third-ranked user is the second incremental user and is allocated the additional
cost that arises from three users instead of two users, and so on.
The Shapley Value method calculates an average cost based on the costs allocated to each
user as first the primary user, the second-ranked user, the third-ranked user, and so on.

15-19 (30 min.) Support department cost allocation; direct and step-down methods.

1. AS IS GOVT CORP
a. Direct method costs $600,000 $2,400,000
Alloc. of AS costs
(40/75, 35/75) (600,000) $ 320,000 $ 280,000
Alloc. of IS costs
(30/90, 60/90) (2,400,000) 800,000 1,600,000
$ 0 $ 0 $1,120,000 $1,880,000
b. Step-down (AS first) costs $600,000 $2,400,000
Alloc. of AS costs
(0.25, 0.40, 0.35) (600,000) 150,000 $ 240,000 $ 210,000
Alloc. of IS costs
(30/90, 60/90) (2,550,000) 850,000 1,700,000
$ 0 $ 0 $1,090,000 $1,910,000

c. Step-down (IS first) costs $600,000 $2,400,000


Alloc. of IS costs
(0.10, 0.30, 0.60) 240,000 (2,400,000) $ 720,000 $1,440,000
Alloc. of AS costs
(40/75, 35/75) (840,000) 448,000 392,000
$ 0 $ 0 $1,168,000 $1,832,000

2. GOVT CORP
Direct method $1,120,000 $1,880,000
Step-down (AS first) 1,090,000 1,910,000
Step-down (IS first) 1,168,000 1,832,000

The direct method ignores any services to other support departments. The step-down method
partially recognizes services to other support departments. The information systems support
group (with total budget of $2,400,000) provides 10% of its services to the AS group. The AS
support group (with total budget of $600,000) provides 25% of its services to the information
systems support group. When the AS group is allocated first, a total of $2,550,000 is then

Accounting 507 Managerial Accounting Winter 2009 31


assigned out from the IS group. Given CORP’s disproportionate (2:1) usage of the services of
IS, this method then results in the highest overall allocation of costs to CORP. By contrast,
GOVT’s usage of the AS group exceeds that of CORP (by a ratio of 8:7), and so GOVT is
assigned relatively more in support costs when AS costs are assigned second, after they have
already been incremented by the AS share of IS costs as well.

3. Three criteria that could determine the sequence in the step-down method are:

a. Allocate support departments on a ranking of the percentage of their total services


provided to other support departments.
1. Administrative Services 25%
2. Information Systems 10%

b. Allocate support departments on a ranking of the total dollar amount in the support
departments.
1. Information Systems $2,400,000
2. Administrative Services $ 600,000

c. Allocate support departments on a ranking of the dollar amounts of service provided


to other support departments

1. Information Systems
(0.10  $2,400,000) = $240,000
2. Administrative Services
(0.25  $600,000) = $150,000

The approach in (a) above typically better approximates the theoretically preferred
reciprocal method. It results in a higher percentage of support-department costs provided to other
support departments being incorporated into the step-down process than does (b) or (c), above.

15-20 (50 min.) Support-department cost allocation, reciprocal method (continuation of 15-19).
1a.

Support Departments Operating Departments
        AS                     I S   Govt. Corp.
Costs  $600,000 $2,400,000
Alloc. of
AS costs
$   344,615 $   301,538
(0.25, 0.40, 0.35)  (861,538)      215,385

Alloc. of IS costs
(0.10, 0.30, 0.60)   
  261,538 (2,615,385)        784,616   1,569,231
  
 $           0 $              0 $1,129,231 $1,870,769

Reciprocal Method Computation


AS = $600,000 + 0.10 IS
IS = $2,400,000 + 0.25AS

Accounting 507 Managerial Accounting Winter 2009 32


IS = $2,400,000 + 0.25 ($600,000 + 0.10 IS)
= $2,400,000 + $150,000 + 0.025 IS
0.975IS = $2,550,000
IS = $2,550,000 ÷ 0.975
= $2,615,385
  AS = $600,000 + 0.10 ($2,615,385)
= $600,000 + $261,538
= $861,538

1b.       
Support Departments Operating Departments
          AS                          I S    Govt.    Corp.
Costs $600,000 $2,400,000
st
1  Allocation of AS
    (0.25, 0.40, 0.35) (600,000)        150,000    $   240,000 $    210,000
  2,550,000
1st Allocation of IS
   (0.10, 0.30, 0.60)   255,000  (2,550,000)         765,000   1,530,000
2nd Allocation of AS
   (0.25, 0.40, 0.35)  (255,000)        63,750         102,000        89,250
2nd Allocation of IS
   (0.10, 0.30, 0.60)       6,375       (63,750)           19,125        38,250
3rd Allocation of AS
   (0.25, 0.40, 0.35)      (6,375)          1,594             2,550          2,231
3rd Allocation of IS
   (0.10, 0.30, 0.60)          160         (1,594)                478             956
4th Allocation of AS
   (0.25, 0.40, 0.35)         (160)               40                  64               56
4th Allocation of IS
   (0.10, 0.30, 0.60)              4              (40)                  12               24
5th Allocation of AS
   (0.25, 0.40, 0.35)             (4)                 1                    2                 1
5th Allocation of IS
   (0.10, 0.30, 0.60)                0                          (1)                    
   0                   1
Total allocation $           0 $              0    $1,129,231 $1,870,769

Accounting 507 Managerial Accounting Winter 2009 33


2.
Govt. Consulting Corp. Consulting
a. Direct $1,120,000 $1,880,000
b. Step-Down (AS first) 1,090,000 1,910,000
c. Step-Down (IS first) 1,168,000 1,832,080
d. Reciprocal (linear equations) 1,129,231 1,870,769
e. Reciprocal (repeated iterations) 1,129,231 1,870,769

The four methods differ in the level of support department cost allocation across support
departments. The level of reciprocal service by support departments is material. Administrative
Services supplies 25% of its services to Information Systems. Information Systems supplies 10%
of its services to Administrative Services. The Information Department has a budget of $2,400,000
that is 400% higher than Administrative Services.
The reciprocal method recognizes all the interactions and is thus the most accurate. This is
especially clear from looking at the repeated iterations calculations.

15-24 (20 min.) Allocation of common costs.

1. Alternative approaches for the allocation of the $1,800 airfare include the following:
a. The stand-alone cost allocation method. This method would allocate the air fare on
the basis of each client’s percentage of the total of the individual stand-alone costs.

$1, 400
Baltimore client
( $1, 400  $1,100 )  $1,800 = $1,008
$1,100
Chicago client
( $1, 400  $1,100 )  $1,800 = 792

$1,800
Advocates of this method often emphasize an equity or fairness rationale.
b. The incremental cost allocation method. This requires the choice of a primary party
and an incremental party.

If the Baltimore client is the primary party, the allocation would be:

Baltimore client $1,400


Chicago client 400
$1,800

One rationale is that Gunn was planning to make the Baltimore trip, and the Chicago stop was
added subsequently. Some students have suggested allocating as much as possible to the
Baltimore client since Gunn had decided not to work for them.

Accounting 507 Managerial Accounting Winter 2009 34


If the Chicago client is the primary party, the allocation would be:

Chicago client $1,100


Baltimore client 700
$1,800

One rationale is that the Chicago client is the one who is going to use Gunn’s services, and
presumably receives more benefits from the travel expenditures.

c. Gunn could calculate the Shapley value that considers each client in turn as the
primary party: The Baltimore client is allocated $1,400 as the primary party and $700 as the
incremental party for an average of ($1,400 + $700) ÷ 2 = $1,050. The Chicago client is
allocated $1,100 as the primary party and $400 as the incremental party for an average of
($1,100 + 400) ÷ 2 = $750. The Shapley value approach would allocate $1,050 to the Baltimore
client and $750 to the Chicago client.

2. I would recommend Gunn use the Shapley value. It is fairer than the incremental method
because it avoids considering one party as the primary party and allocating more of the common
costs to that party. It also avoids disputes about who is the primary party. It allocates costs in a
manner that is close to the costs allocated under the stand-alone method but takes a more
comprehensive view of the common cost allocation problem by considering primary and
incremental users, which the stand-alone method ignores.
The Shapley value (or the stand-alone cost allocation method) would be the preferred
methods if Gunn was to send the travel expenses to the Baltimore and Chicago clients before
deciding which engagement to accept. Other factors such as whether to charge the Chicago client
more because Gunn is accepting the Chicago engagement or the Baltimore client more because
Gunn is not going to work for them can be considered if Gunn sends in her travel expenses after
making her decision. However, each company would not want to be considered as the primary
party and so is likely to object to these arguments.

3. A simple approach is to split the $60 equally between the two clients. The limousine costs
at the Sacramento end are not a function of distance traveled on the plane.

An alternative approach is to add the $60 to the $1,800 and repeat requirement 1:

a. Stand-alone cost allocation method.


$1, 460
Baltimore client
( $1, 460  $1,160 )  $1,860 = $1,036
$1,160
Chicago client
( $1, 460  $1,160 )  $1,860 = $ 824
b. Incremental cost allocation method.

With Baltimore client as the primary party:


Baltimore client $1,460
Chicago client 400
$1,860

Accounting 507 Managerial Accounting Winter 2009 35


With Chicago client as the primary party:
Chicago client $1,160
Baltimore client 700
$1,860

c. Shapley value.
Baltimore client: ($1,460 + $700) ÷ 2 = $1,080
Chicago client: ($400 + $1,160) ÷ 2 = $ 780

As discussed in requirement 2, the Shapley value or the stand-alone cost allocation


method would probably be the preferred approaches.

Note: If any students in the class have faced this situation when visiting prospective employers,
ask them how they handled it.

15-32 (25 min.) Common costs.

1. Stand-alone cost-allocation method.

(900 �$40)
Wright, Inc. = �(1,500 �$32)
(900 �$40)  (600 �$40)

$36, 000
= �$48, 000 = $28,800
($36, 000  $24, 000)

(600 �$40)
Brown, Inc. = �(1,500 �$32)
(900 �$40)  (600 �$40)

$24, 000
= �$48, 000 = $19,200
($36, 000  $24, 000)

Accounting 507 Managerial Accounting Winter 2009 36


2. With Wright, Inc. as the primary party:
Cumulative Costs
Party Costs Allocated Allocated
Wright $36,000 $36,000
Brown 12,000 ($48,000 – $36,000) $48,000
Total $48,000

With Brown, Inc. as the primary party:


Cumulative Costs
Party Costs Allocated Allocated
Brown $24,000 $24,000
Wright 24,000 ($48,000 – $24,000) $48,000
Total $48,000

3. To use the Shapley value method, consider each party as first the primary party and then
the incremental party. Compute the average of the two to determine the allocation.

Wright, Inc.:
Allocation as the primary party $36,000
Allocation as the incremental party 24,000
Total $60,000
Allocation ($60,000 ÷ 2) $30,000

Brown, Inc.:
Allocation as the primary party $24,000
Allocation as the incremental party 12,000
Total $36,000
Allocation ($36,000 ÷ 2) $18,000

Using this approach, Wright, Inc. is allocated $30,000 and Brown, Inc. is allocated $18,000 of
the total costs of $48,000.

4. The results of the four cost-allocation methods are shown below.

Wright, Inc. Brown, Inc.


Stand-alone method $28,800 $19,200
Incremental (Wright primary) 36,000 12,000
Incremental (Brown primary) 24,000 24,000
Shapley value 30,000 18,000

The allocations are very sensitive to the method used. The stand-alone method is simple and
fair since it allocates the common cost of the dyeing machine in proportion to the individual
costs of leasing the machine. The Shapley values are also fair. They result in very similar
allocations and any one of them can be chosen. In this case, the stand-alone method is likely
more acceptable. If they used the incremental cost-allocation method, Wright, Inc. and Brown,
Inc. would probably have disputes over who is the primary party because the primary party gets
allocated all of the primary party’s costs.

Accounting 507 Managerial Accounting Winter 2009 37


CHAPTER 16
16-16 (20-30 min.) Joint-cost allocation, insurance settlement.

1. (a) Sales value at splitoff method:

Pounds Wholesale Sales Weighting: Joint Allocated


of Selling Price Value Sales Value Costs Costs per
Product per Pound at Splitoff at Splitoff Allocated Pound
Breasts 100 $0.55 $55.00 0.675 $33.75 0.3375
Wings 20 0.20 4.00 0.049 2.45 0.1225
Thighs 40 0.35 14.00 0.172 8.60 0.2150
Bones 80 0.10 8.00 0.098 4.90 0.0613
Feathers 10 0.05 0.50 0.006 0.30 0.0300
250 $81.50 1.000 $50.00

Costs of Destroyed Product


Breasts: $0.3375 per pound  40 pounds = $13.50
Wings: $0.1225 per pound  15 pounds = 1.84
$15.34
b. Physical measure method:

Pounds Weighting: Joint Allocated


of Physical Costs Costs per
Product Measures Allocated Pound
Breasts 100 0.400 $20.00 $0.200
Wings 20 0.080 4.00 0.200
Thighs 40 0.160 8.00 0.200
Bones 80 0.320 16.00 0.200
Feathers 10 0.040 2.00 0.200
250 1.000 $50.00

Costs of Destroyed Product


Breast: $0.20 per pound  40 pounds = $ 8
Wings: $0.20 per pound  15 pounds = 3
$11

Accounting 507 Managerial Accounting Winter 2009 38


Note: Although not required, it is useful to highlight the individual product profitability figures:

Sales Value at Physical


Splitoff Method Measures Method
Sales Joint Costs Gross Joint Costs Gross
Product Value Allocated Income Allocated Income
Breasts $55.00 $33.75 $21.25 $20.00 $35.00
Wings 4.00 2.45 1.55 4.00 0.00
Thighs 14.00 8.60 5.40 8.00 6.00
Bones 8.00 4.90 3.10 16.00 (8.00)
Feathers 0.50 0.30 0.20 2.00 (1.50)

2. The sales-value at splitoff method captures the benefits-received criterion of cost


allocation and is the preferred method. The costs of processing a chicken are allocated to
products in proportion to the ability to contribute revenue. Quality Chicken’s decision to process
chicken is heavily influenced by the revenues from breasts and thighs. The bones provide
relatively few benefits to Quality Chicken despite their high physical volume.
The physical measures method shows profits on breasts and thighs and losses on bones
and feathers. Given that Quality Chicken has to jointly process all the chicken products, it is non-
intuitive to single out individual products that are being processed simultaneously as making
losses while the overall operations make a profit. Quality Chicken is processing chicken mainly
for breasts and thighs and not for wings, bones, and feathers, while the physical measure method
allocates a disproportionate amount of costs to wings, bones and feathers.

16-21 (30 min.) Joint-cost allocation, process further.

ICR8 Processing Crude Oil


150 bbls × $18 / bbl =
(Non-Saleable) $175 $2700

ING4 Processing NGL


Joint Costs = 50 bbls × $15 / bbl =
$1800 (Non-Saleable) $105 $750

Gas
XGE3 Processing 800 eqvt bbls ×
(Non-Saleable) $210 $1.30 / eqvt bbl =
$1040
Splitoff
Point

Accounting 507 Managerial Accounting Winter 2009 39


1a. Physical Measure Method

Crude Oil NGL Gas Total


1. Physical measure of total prodn. 150 800
2. Weighting (150; 50; 800 ÷ 1,000) 0.15 50 0.80 1,000
3. Joint costs allocated (Weights  $1,800) $270
0.05 $1,440 1.00

$90 $1,800

1b. NRV Method

Crude Oil NGL Gas Total


1. Final sales value of total production
2. Deduct separable costs $2,700 $750 $1,040 $4,490
3. NRV at splitoff
4. Weighting (2,525; 645; 830 ÷ 4,000) 175 105 210 490
5. Joint costs allocated (Weights  $1,800) $
$2,525 $645 830 $4,000

0.63125 0.16125 0.20750


$1,136.25 $1,800
$290.25 $373.50

Accounting 507 Managerial Accounting Winter 2009 40


2. The operating-income amounts for each product using each method is:

(a) Physical Measure Method

Crude Oil NGL Gas Total


Revenues $2,700 $750 $1,040 $4,490
Cost of goods sold
Joint costs 270 90 1,440 1,800
Separable costs 175 105 210 490
Total cost of goods sold 445 195 1,650 2,290
Gross margin $2,255 $555 $ (610) $2,200

(b) NRV Method

Crude Oil NGL Gas Total


Revenues $2,700.00 $750.00 $1,040.00 $4,490.00
Cost of goods sold
Joint costs 1,136.25 290.25 373.50 1,800.00
Separable costs 175.00 105.00 210.00 490.00
Total cost of goods sold 1,311.25 395.25 583.50 2,290.00
Gross margin $1,388.75 $354.75 $ 456.50 $2,200.00

3. Neither method should be used for product emphasis decisions. It is inappropriate to use
joint-cost-allocated data to make decisions regarding dropping individual products, or pushing
individual products, as they are joint by definition. Product-emphasis decisions should be made
based on relevant revenues and relevant costs. Each method can lead to product emphasis
decisions that do not lead to maximization of operating income.

4. Since crude oil is the only product subject to taxation, it is clearly in Sinclair’s best interest to
use the NRV method since it leads to a lower profit for crude oil and, consequently, a smaller tax
burden. A letter to the taxation authorities could stress the conceptual superiority of the NRV
method. Chapter 16 argues that, using a benefits-received cost allocation criterion, market-based
joint cost allocation methods are preferable to physical-measure methods. A meaningful common
denominator (revenues) is available when the sales value at splitoff point method or NRV
method is used. The physical-measures method requires nonhomogeneous products (liquids and
gases) to be converted to a common denominator.

Accounting 507 Managerial Accounting Winter 2009 41


16.22 (30 min.) Joint-cost allocation, sales value, physical measure, NRV methods.
1a.
Special B/ Special S/
PANEL A: Allocation of Joint Costs using Sales Value at Beef Shrimp
Splitoff Method Ramen Ramen Total
Sales value of total production at splitoff point
(10,000 tons �$10 per ton; 20,000 �$15 per ton) $100,000 $300,000 $400,000
Weighting ($100,000; $300,000 ÷ $400,000) 0.25 0.75
Joint costs allocated (0.25; 0.75 �$240,000) $60,000 $180,000 $240,000

PANEL B: Product-Line Income Statement for June 2009 Special B Special S Total
Revenues
(12,000 tons �$18 per ton; 24,000 �$25 per ton) $216,000 $600,000 $816,000
Deduct joint costs allocated (from Panel A) 60,000 180,000 240,000
Deduct separable costs 48,000 168,000 216,000
Gross margin $108,000 $252,000 $360,000
Gross margin percentage 50% 42% 44%

1b.
Special B/ Special S/
PANEL A: Allocation of Joint Costs using Physical-Measure Beef Shrimp
Method Ramen Ramen Total
Physical measure of total production (tons) 10,000 20,000 30,000
Weighting (10,000 tons; 20,000 tons ÷ 30,000 tons) 33% 67%
Joint costs allocated (0.33; 0.67 �$240,000) $80,000 $160,000 $240,000

PANEL B: Product-Line Income Statement for June 2009 Special B Special S Total
Revenues
(12,000 tons �$18 per ton; 24,000 �$25 per ton) $216,000 $600,000 $816,000
Deduct joint costs allocated (from Panel A) 80,000 160,000 240,000
Deduct separable costs 48,000 168,000 216,000
Gross margin $ 88,000 $272,000 $360,000
Gross margin percentage 41% 45% 44%

1c.
PANEL A: Allocation of Joint Costs using Net Realizable
Value Method Special B Special S Total
Final sales value of total production during accounting period
(12,000 tons �$18 per ton; 24,000 tons �$25 per ton) $216,000 $600,000 $816,000
Deduct separable costs 48,000 168,000 216,000
Net realizable value at splitoff point $168,000 $432,000 $600,000
Weighting ($168,000; $432,000 ÷ $600,000) 28% 72%
Joint costs allocated (0.28; 0.72 �$240,000) $67,200 $172,800 $240,000

PANEL B: Product-Line Income Statement for June 2009 Special B Special S Total
Revenues (12,000 tons �$18 per ton; 24,000 tons �$25 per ton) $216,000 $600,000 $816,000
Deduct joint costs allocated (from Panel A) 67,200 172,800 240,000
Deduct separable costs 48,000 168,000 216,000
Gross margin $100,800 $259,200 $360,000
Gross margin percentage 46.7% 43.2% 44.1%

Accounting 507 Managerial Accounting Winter 2009 42


2. Sherrie Dong probably performed the analysis shown below to arrive at the net loss of
$2,228 from marketing the stock:

Special B/ Special S/
PANEL A: Allocation of Joint Costs using Beef Shrimp
Sales Value at Splitoff Ramen Ramen Stock Total
Sales value of total production at splitoff point
(10,000 tons �$10 per ton; 20,000 �$15 per
ton; 4,000 �$5 per ton) $100,000 $300,000 $20,000 $420,000
Weighting
($100,000; $300,000; $20,000 ÷ $420,000) 23.8095% 71.4286% 4.7619% 100%
Joint costs allocated
(0.238095; 0.714286; 0.047619 �$240,000) $57,143 $171,429 $11,428 $240,000

PANEL B: Product-Line Income Statement


for June 2009 Special B Special S Stock Total
Revenues
(12,000 tons �$18 per ton; 24,000 �$25 per ton;
4,000 �$5 per ton) $216,000 $600,000 $20,000 $836,000
Separable processing costs 48,000 168,000 0 216,000
Joint costs allocated (from Panel A) 57,143 171,429 11,428 240,000
Gross margin $110,857 $260,571 8,572 380,000
Deduct marketing costs 10,800 10,800
Operating income $ (2,228) $369,200

In this (misleading) analysis, the $240,000 of joint costs are re-allocated between Special B,
Special S, and the stock. Irrespective of the method of allocation, this analysis is wrong. Joint
costs are always irrelevant in a process-further decision. Only incremental costs and revenues
past the splitoff point are relevant. In this case, the correct analysis is much simpler: the
incremental revenues from selling the stock are $20,000, and the incremental costs are the
marketing costs of $10,800. So, Instant Foods should sell the stock—this will increase its
operating income by $9,200 ($20,000 – $10,800).

16-29 (30 min.) Joint-cost allocation, process further or sell.

A diagram of the situation is in Solution Exhibit 16-29.

1.
a. Sales value at splitoff method.
Monthly Selling Sales Value
Unit Price of Total Prodn. Joint Costs
Output Per Unit at Splitoff Weighting Allocated
Studs (Building) 75,000 $ 8 $ 600,000 46.1539% $ 461,539
Decorative Pieces 5,000 60 300,000 23.0769 230,769
Posts 20,000 20 400,000 30.7692 307,692
Totals $1,300,000 100.0000% $1,000,000

b. Physical measure method.

Accounting 507 Managerial Accounting Winter 2009 43


Physical
Measure of Joint Costs
Total Prodn. Weighting Allocated
Studs (Building) 75,000 75.00% $ 750,000
Decorative Pieces 5,000 5.00 50,000
Posts 20,000 20.00 200,000
Totals 100,000 100.00% $1,000,000

c. Net realizable value method.


Fully
Processed Net
Monthly Selling Realizable
Units of Price Value at Joint Costs
Total Prodn. per Unit Splitoff Weighting Allocated
Studs (Building) 75,000 $ 8 $ 600,000 44.4445% $ 444,445
Decorative Pieces 4,500a 100 350,000b 25.9259 259,259
Posts 20,000 20 400,000 29.6296 296,296
Totals $1,350,000 100.0000% $1,000,000
a
5,000 monthly units of output – 10% normal spoilage = 4,500 good units.
b
4,500 good units  $100 = $450,000 – Further processing costs of $100,000 = $350,000

2. Presented below is an analysis for Sonimad Sawmill, Inc., comparing the processing of
decorative pieces further versus selling the rough-cut product immediately at splitoff:

Units Dollars
Monthly unit output 5,000
Less: Normal further processing shrinkage 500
Units available for sale 4,500
Final sales value (4,500 units  $100 per unit) $450,000
Less: Sales value at splitoff 300,000
Incremental revenue 150,000
Less: Further processing costs 100,000
Additional contribution from further processing $ 50,000

3. Assuming Sonimad Sawmill, Inc., announces that in six months it will sell the rough-cut
product at splitoff due to increasing competitive pressure, behavior that may be demonstrated by
the skilled labor in the planing and sizing process include the following:

 lower quality,
 reduced motivation and morale, and
 job insecurity, leading to nonproductive employee time looking for jobs elsewhere.

Accounting 507 Managerial Accounting Winter 2009 44


Management actions that could improve this behavior include the following:

 Improve communication by giving the workers a more comprehensive explanation as


to the reason for the change so they can better understand the situation and bring out a
plan for future operation of the rest of the plant.
 The company can offer incentive bonuses to maintain quality and production and
align rewards with goals.
 The company could provide job relocation and internal job transfers.

SOLUTION EXHIBIT 16-29

Joint Costs Separable Costs


$1,000,000

Studs
$8 per unit

Raw Decorative Decorative


Pieces Processing
Processing Pieces
$60 per unit $100000
$100 per unit

Posts
$20 per unit

Splitoff
Point

Accounting 507 Managerial Accounting Winter 2009 45


16-32 (20 min.) Joint-cost allocation with a byproduct.

1. Sales value at splitoff method: Byproduct recognized at time of production method

Joint cost to be charged to joint products = Joint Cost – NRV of Byproduct


= $10,000 – 1000 tons × 20% × 0.25 vats × $60
= $10,000 – 50 vats × $60
= $ 7,000

Grade A Grade B Total


Coal Coal
Sales value of coal at splitoff,
1,000 tons × 0.4 × $100; 1,000 tons × 0.4 × $60 $40,000 $24,000 $64,000
Weighting, $40,000; $24,000 �$64,000 0.625 0.375
Joint costs allocated,
0.625; 0.375 × $7,000 $ 4,375 $ 2,625 $ 7,000
Gross margin (Sales revenue ─ Allocated cost) $35,625 $21,375 $57,000

2. Sales value at splitoff method: Byproduct recognized at time of sale method

Joint cost to be charged to joint products = Total Joint Cost = $10,000

Grade A Grade B Total


Coal Coal
Sales value of coal splitoff,
1,000 tons × .4 × $100; 1,000 tons × .4 × $60 $40,000 $24,000 $64,000
Weighting, $40,000; $24,000 �$64,000 0.625 0.375
Joint costs allocated,
0.625; 0.375 × $10,000 $ 6,250 $ 3,750 $10,000
Gross margin (Sales revenue ─ Allocated cost) $33,750 $20,250 $54,000

Since the entire production is sold during the period, the overall gross margin is the same
under the production and sales methods. In particular, under the sales method, the $3,000
received from the sale of the coal tar is added to the overall revenues, so that Cumberland’s
overall gross margin is $57,000, as in the production method.

3. The production method of accounting for the byproduct is only appropriate if


Cumberland is positive they can sell the byproduct and positive of the selling price.
Moreover, Cumberland should view the byproduct’s contribution to the firm as material
enough to find it worthwhile to record and track any inventory that may arise. The sales
method is appropriate if either the disposition of the byproduct is unsure or the selling price
is unknown, or if the amounts involved are so negligible as to make it economically
infeasible for Cumberland to keep track of byproduct inventories.

Accounting 507 Managerial Accounting Winter 2009 46


CHAPTER 5
5­16 (20 min.)   Cost hierarchy.

1. a. Indirect manufacturing labor costs of $1,200,000 support direct manufacturing labor


and are output unit-level costs. Direct manufacturing labor generally increases with
output units, and so will the indirect costs to support it.
b. Batch-level costs are costs of activities that are related to a group of units of a product
rather than each individual unit of a product. Purchase order-related costs (including
costs of receiving materials and paying suppliers) of $600,000 relate to a group of
units of product and are batch-level costs.
c. Cost of indirect materials of $350,000 generally changes with labor hours or machine
hours which are unit-level costs. Therefore, indirect material costs are output unit-
level costs.
d. Setup costs of $700,000 are batch-level costs because they relate to a group of units
of product produced after the machines are set up.
e. Costs of designing processes, drawing process charts, and making engineering
changes for individual products, $900,000, are product-sustaining because they relate
to the costs of activities undertaken to support individual products regardless of the
number of units or batches in which the product is produced.
f. Machine-related overhead costs (depreciation and maintenance) of $1,200,000 are
output unit-level costs because they change with the number of units produced.
g. Plant management, plant rent, and insurance costs of $950,000 are facility-sustaining
costs because the costs of these activities cannot be traced to individual products or
services but support the organization as a whole.
2. The complex boom box made in many batches will use significantly more batch-level
overhead resources compared to the simple boom box that is made in a few batches. In addition,
the complex boom box will use more product-sustaining overhead resources because it is
complex. Because each boom box requires the same amount of machine-hours, both the simple
and the complex boom box will be allocated the same amount of overhead costs per boom box if
Teledor uses only machine-hours to allocate overhead costs to boom boxes. As a result, the
complex boom box will be undercosted (it consumes a relatively high level of resources but is
reported to have a relatively low cost) and the simple boom box will be overcosted (it consumes
a relatively low level of resources but is reported to have a relatively high cost).

3. Using the cost hierarchy to calculate activity-based costs can help Teledor to identify both
the costs of individual activities and the cost of activities demanded by individual products.
Teledor can use this information to manage its business in several ways:

a. Pricing and product mix decisions. Knowing the resources needed to manufacture and
sell different types of boom boxes can help Teledor to price the different boom boxes
and also identify which boom boxes are more profitable. It can then emphasize its
more profitable products.

Accounting 507 Managerial Accounting Winter 2009 47


b. Teledor can use information about the costs of different activities to improve
processes and reduce costs of the different activities. Teledor could have a target of
reducing costs of activities (setups, order processing, etc.) by, say, 3% and constantly
seek to eliminate activities and costs (such as engineering changes) that its customers
perceive as not adding value.
c. Teledor management can identify and evaluate new designs to improve performance
by analyzing how product and process designs affect activities and costs.
d. Teledor can use its ABC systems and cost hierarchy information to plan and manage
activities. What activities should be performed in the period and at what cost?

5-27 (30 min.) ABC, product-costing at banks, cross-subsidization.

1.
Robinson Skerrett Farrel Total
Revenues
Spread revenue on annual basis
(3%  ; $1,100, $800, $25,000) $ 33 $ 24 $750.00 $ 807.00
Monthly fee charges
($20 ; 0, 12, 0) 0 240 0.00 240.00
Total revenues 33 264 750.00 1,047.00
Costs
Deposit/withdrawal with teller
$2.50 �40; 50; 5 100 125 12.50 237.50
Deposit/withdrawal with ATM
$0.80 �10; 20; 16 8 16 12.80 36.80
Deposit/withdrawal on prearranged basis
$0.50 �0; 12; 60 0 6 30.00 36.00
Bank checks written
$8.00 �9; 3; 2 72 24 16.00 112.00
Foreign currency drafts
$12.00 �4; 1; 6 48 12 72.00 132.00
Inquiries
$1.50 �10; 18; 9 15 27 13.50 55.50
Total costs 243 210 156.80 609.80
Operating income (loss) $(210) $ 54 $593.20 $ 437.20

The assumption that the Robinson and Farrel accounts exceed $1,000 every month and
the Skerrett account is less than $1,000 each month means the monthly charges apply only to
Skerrett.
One student with a banking background noted that in this solution 100% of the spread is
attributed to the “depositor side of the bank.” He noted that often the spread is divided between
the “depositor side” and the “lending side” of the bank.

2. Cross-subsidization across individual Premier Accounts occurs when profits made on


some accounts are offset by losses on other accounts. The aggregate profitability on the three

Accounting 507 Managerial Accounting Winter 2009 48


customers is $437.20. The Farrel account is highly profitable ($593.20), while the Robinson
account is sizably unprofitable. The Skerrett account shows a small profit but only because of the
$240 monthly fees. It is unlikely that Skerrett will keep paying these high fees and that FIB
would want Skerret to pay such high fees from a customer relationship standpoint.
The facts also suggest that the customers do not use the bank services uniformly. For
example, Robinson and Skerret have a lot of transactions with the teller or ATM, and also inquire
about their account balances more often than Farrell. This suggests cross-subsidization. FIB
should be very concerned about the cross-subsidization. Competition likely would “understand”
that high-balance low-activity type accounts (such as Farrel) are highly profitable. Offering free
services to these customers is not likely to retain these accounts if other banks offer higher
interest rates. Competition likely will reduce the interest rate spread FIB can earn on the high-
balance low-activity accounts they are able to retain.

3. Possible changes FIB could make are:


a. Offer higher interest rates on high-balance accounts to increase FIB’s competitiveness
in attracting and retaining these accounts.
b. Introduce charges for individual services. The ABC study reports the cost of each
service. FIB has to decide if it wants to price each service at cost, below cost, or
above cost. If it prices above cost, it may use advertising and other means to
encourage additional use of those services by customers. Of course, in determining its
pricing strategy, FIB would need to consider how other competing banks are pricing
their products and services.

Accounting 507 Managerial Accounting Winter 2009 49


5-34 (30–40 min.) Activity-based costing, merchandising.

1. General Mom-and-Pop
Supermarket Drugstore Single
Chains Chains Stores Total
Revenues $3,708,000 $3,150,000 $1,980,000 $8,838,000
Cost of goods sold 3,600,000 3,000,000 1,800,000 8,400,000
Gross margin $ 108,000 $ 150,000 $ 180,000 $ 438,000
Other operating costs 301,080
Operating income $ 136,920

Gross margin % 2.91% 4.76% 9.09%

The gross margin of Pharmacare, Inc., was 4.96% ($438,000 ÷ $8,838,000). The
operating income margin of Pharmacare, Inc., was 1.55% ($136,920 ÷ $8,838,000).

2. The per-unit cost driver rates are:

1. Customer purchase order processing,


$80,000 ÷ 2,000 (140 + 360 + 1,500) orders = $40 per order
2. Line item ordering,
$63,840 ÷ 21,280 (1,960 + 4,320 + 15,000) line items = $ 3 per line item
3. Store delivery,
$71,000 ÷ 1,480 (120 + 360 + 1,000) deliveries = $47.973 per delivery
4. Cartons shipped,
$76,000 ÷ 76,000 (36,000 + 24,000 + 16,000) cartons = $ 1 per carton
5. Shelf-stocking,
$10,240 ÷ 640 (360 + 180 + 100) hours = $16 per hour

2. The activity-based costing of each distribution market for August 2008 is:

General Mom-and-
Supermarket Drugstore Pop
Chains Chains Single Stores Total
1. Customer purchase order processing
($40  140; 360; 1,500) $ 5,600 $14,400 $ 60,000 $ 80,000
2. Line item ordering
($3  1,960; 4,320; 15,000) 5,880 12,960 45,000 63 ,840
3. Store delivery,
($47.973  120; 360; 1,000) 5,757 17,270 47,973 71,000
4. Cartons shipped
($1  36,000; 24,000; 16,000) 36,000 24,000 16,000 76,000
5. Shelf-stocking
($16  360; 180; 100) 5,760 2,880 1,600 10,240
$58,997 $71,510 $170,573 $301,080

Accounting 507 Managerial Accounting Winter 2009 50


The revised operating income statement is:
General Mom-and-Pop
Supermarket Drugstore Single
Chains Chains Stores Total
Revenues $3,708,000 $3,150,000 $1,980,000 $8,838,000
Cost of goods sold 3,600,000 3,000,000 1,800,000 8,400,000
Gross margin 108,000 150,000 180,000 438,000
Operating costs 58,997 71,510 170,573 301,080
Operating income $ 49,003 $ 78,490 $ 9,427 $ 136,920

Operating income margin 1.32% 2.49% 0.48% 1.55%

4. The ranking of the three markets are:

Using Gross Margin Using Operating Income

1. Mom-and-Pop Single Stores 9.09% 1. Drugstore Chains 2.49%


2. Drugstore Chains 4.76% 2. General Supermarket Chains 1.32%
3. General Supermarket Chains 2.91% 3. Mom-and-Pop Single Stores 0.48%

The activity-based analysis of costs highlights how the Mom-and-Pop Single Stores use a larger
amount of Pharmacare’s resources per revenue dollar than do the other two markets. The ratio of
the operating costs to revenues across the three markets is:

General Supermarket Chains 1.59% ($58,997 ÷ $3,708,000)


Drugstore Chains 2.27% ($71,510 ÷ $3,150,000)
Mom-and-Pop Single Stores 8.61% ($170,573 ÷ $1,980,000)

This is a classic illustration of the maxim that “all revenue dollars are not created equal.” The
analysis indicates that the Mom-and-Pop Single Stores are the least profitable market.
Pharmacare should work to increase profits in this market through: (1) a possible surcharge, (2)
decreasing the number of orders, (3) offering discounts for quantity purchases, etc.

Other issues for Pharmacare to consider include


a. Choosing the appropriate cost drivers for each area. The problem gives a cost driver
for each chosen activity area. However, it is likely that over time further refinements
in cost drivers would occur. For example, not all store deliveries are equally easy to
make, depending on parking availability, accessibility of the storage/shelf space to the
delivery point, etc. Similarly, not all cartons are equally easy to deliver––their weight,
size, or likely breakage component are factors that can vary across carton types.

b. Developing a reliable data base on the chosen cost drivers. For some items, such as
the number of orders and the number of line items, this information likely would be
available in machine readable form at a high level of accuracy. Unless the delivery
personnel have hand-held computers that they use in a systematic way, estimates of
shelf-stocking time are likely to be unreliable. Advances in information technology
likely will reduce problems in this area over time.

Accounting 507 Managerial Accounting Winter 2009 51


c. Deciding how to handle costs that may be common across several activities. For
example, (3) store delivery and (4) cartons shipped to stores have the common cost of
the same trip. Some organizations may treat (3) as the primary activity and attribute
only incremental costs to (4). Similarly, (1) order processing and (2) line item
ordering may have common costs.

d. Behavioral factors are likely to be a challenge to Flair. He must now tell those
salespeople who specialize in Mom-and-Pop accounts that they have been less
profitable than previously thought.

5-36 (40 min.) ABC, health care.

Medical supplies costs $300,000


1a. Medical supplies rate = Total number of patient - years
=
150

= $2,000/patient-year

Rent and clinic maint. costs $180,000


= Total amount of square feet of space
= 30,000

= $6 per square foot

Admin. costs to manage patient


$600,000
= charts, food, laundry =
150
Total number of patient - years

= $4,000/patient-year

Laboratory services costs $100,000


Laboratory services rate = Total number of laboratory tests
= 2,500

= $40 per test

These cost drivers are chosen as the ones that best match the descriptions of why the costs arise.
Other answers are acceptable, provided that clear explanations are given.

1b. Activity-based costs for each program and cost per patient-year of the alcohol and drug
program follow:

Accounting 507 Managerial Accounting Winter 2009 52


Alcohol Drug After-Care Total

Direct labor

Physicians at $150,000 × 0; 4; 0 — $ 600,000 — $ 600,000

Psychologists at $75,000 × 6; 4; 8 $450,000 300,000 $ 600,000 1,350,000

Nurses at $30,000 × 4; 6; 10 120,000 180,000 300,000 600,000

Direct labor costs 570,000 1,080,000 900,000 2,550,000

Medical supplies1 $2,000 × 40; 50; 60 80,000 100,000 120,000 300,000

Rent and clinic maintenance2

$6 × 9,000; 9,000; 12,000 54,000 54,000 72,000 180,000

Administrative costs to manage

patient charts, food, and laundry3

$4,000 × 40; 50; 60 160,000 200,000 240,000 600,000

Laboratory services4 $40 × 400; 1,400; 700 16,000 56,000 28,000 100,000

Total costs $880,000 $1,490,000 $1,360,000 $3,730,000

$880,000 $1,490,000
Cost per patient-year = $22,000 = $29,800
40 50
1
Allocated using patient-years
2
Allocated using square feet of space
3
Allocated using patient-years
4
Allocated using number of laboratory tests

1c. The ABC system more accurately allocates costs because it identifies better cost drivers.
The ABC system chooses cost drivers for overhead costs that have a cause-and-effect
relationship between the cost drivers and the costs. Of course, Clayton should continue to
evaluate if better cost drivers can be found than the ones they have identified so far.
By implementing the ABC system, Clayton can gain a more detailed understanding of
costs and cost drivers. This is valuable information from a cost management perspective. The
system can yield insight into the efficiencies with which various activities are performed.
Clayton can then examine if redundant activities can be eliminated. Clayton can study trends and
work toward improving the efficiency of the activities.
In addition, the ABC system will help Clayton determine which programs are the most
costly to operate. This will be useful in making long-run decisions as to which programs to offer

Accounting 507 Managerial Accounting Winter 2009 53


or emphasize. The ABC system will also assist Clayton in setting prices for the programs that
more accurately reflect the costs of each program.

2. The concern with using costs per patient-year as the rule to allocate resources among its
programs is that it emphasizes “input” to the exclusion of “outputs” or effectiveness of the
programs. After-all, Clayton’s goal is to cure patients while controlling costs, not minimize costs
per-patient year. The problem, of course, is measuring outputs.
Unlike many manufacturing companies, where the outputs are obvious because they are
tangible and measurable, the outputs of service organizations are more difficult to measure.
Examples are “cured” patients as distinguished from “processed” or “discharged” patients,
“educated” as distinguished from “partially educated” students, and so on.

5-39 (50 min.) ABC, implementation, ethics.

1. Applewood Electronics should not emphasize the Regal model and should not phase out
the Monarch model. Under activity-based costing, the Regal model has an operating income
percentage of less than 3%, while the Monarch model has an operating income percentage of
nearly 43%.

Cost driver rates for the various activities identified in the activity-based costing (ABC) system
are as follows:
Soldering $ 942,000  1,570,000 = $ 0.60 per solder point
Shipments 860,000  20,000 = 43.00 per shipment
Quality control 1,240,000  77,500 = 16.00 per inspection
Purchase orders 950,400  190,080 = 5.00 per order
Machine power 57,600  192,000 = 0.30 per machine-hour
Machine setups 750,000  30,000 = 25.00 per setup

Accounting 507 Managerial Accounting Winter 2009 54


Applewood Electronics

Calculation of Costs of Each Model under Activity-Based Costing

Monarch Regal
Direct costs
Direct materials ($208  22,000; $584  4,000) $ 4,576,000 $2,336,000
Direct manufacturing labor ($18  22,000; $42  4,000) 396,000 168,000
Machine costs ($144  22,000; $72  4,000) 3,168,000 288,000
Total direct costs 8,140,000 2,792,000
Indirect costs
Soldering ($0.60  1,185,000; $0.60  385,000) 711,000 231,000
Shipments ($43  16,200; $43  3,800) 696,600 163,400
Quality control ($16  56,200; $16  21,300) 899,200 340,800
Purchase orders ($5  80,100; $5  109,980) 400,500 549,900
Machine power ($0.30  176,000; $0.30  16,000) 52,800 4,800
Machine setups ($25  16,000; $25  14,000) 400,000 350,000
Total indirect costs 3,160,100 1,639,900
Total costs $11,300,100 $4,431,900

Profitability analysis
Monarch Regal Total
Revenues $19,800,000 $4,560,000 $24,360,000
Cost of goods sold 11,300,100 4,431,900 15,732,000
Gross margin $ 8,499,900 $ 128,100 $ 8,628,000

Per-unit calculations:
Units sold 22,000 4,000
Selling price
($19,800,000  22,000;
$4,560,000  4,000) $900.00 $1,140.00
Cost of goods sold
($11,300,100  22,000;
$4,431,900  4,000) 513.64 1,107.98
Gross margin $386.36 $ 32.02
Gross margin percentage 42.9% 2.8%

2. Applewood’s simple costing system allocates all manufacturing overhead other than
machine costs on the basis of machine-hours, an output unit-level cost driver. Consequently, the
more machine-hours per unit that a product needs, the greater the manufacturing overhead
allocated to it. Because Monarch uses twice the number of machine-hours per unit compared to
Regal, a large amount of manufacturing overhead is allocated to Monarch.
The ABC analysis recognizes several batch-level cost drivers such as purchase orders,
shipments, and setups. Regal uses these resources much more intensively than Monarch. The
ABC system recognizes Regal’s use of these overhead resources. Consider, for example,
purchase order costs. The simple system allocates these costs on the basis of machine-hours. As a
result, each unit of Monarch is allocated twice the purchase order costs of each unit of Regal.
The ABC system allocates $400,500 of purchase order costs to Monarch (equal to $18.20

Accounting 507 Managerial Accounting Winter 2009 55


($400,500  22,000) per unit) and $549,900 of purchase order costs to Regal (equal to $137.48
($549,900  4,000) per unit). Each unit of Regal uses 7.55 ($137.48  $18.20) times the
purchases order costs of each unit of Monarch.
Recognizing Regal’s more intensive use of manufacturing overhead results in Regal
showing a much lower profitability under the ABC system. By the same token, the ABC analysis
shows that Monarch is quite profitable. The simple costing system overcosted Monarch, and so
made it appear less profitable.

3. Duval’s comments about ABC implementation are valid. When designing and
implementing ABC systems, managers and management accountants need to trade off the costs
of the system against its benefits. Adding more activities would make the system harder to
understand and more costly to implement but it would probably improve the accuracy of cost
information, which, in turn, would help Applewood make better decisions. Similarly, using
inspection-hours and setup-hours as allocation bases would also probably lead to more accurate
cost information, but it would increase measurement costs.

4. Activity-based management (ABM) is the use of information from activity-based costing


to make improvements in a firm. For example, a firm could revise product prices on the basis of
revised cost information. For the long term, activity-based costing can assist management in
making decisions regarding the viability of product lines, distribution channels, marketing
strategies, etc. ABM highlights possible improvements, including reduction or elimination of
non-value-added activities, selecting lower cost activities, sharing activities with other products,
and eliminating waste. ABM is an integrated approach that focuses management’s attention on
activities with the ultimate aim of continuous improvement. As a whole-company philosophy,
ABM focuses on strategic, as well as tactical and operational activities of the company.

5. Incorrect reporting of ABC costs with the goal of retaining both the Monarch and Regal
product lines is unethical. In assessing the situation, the specific “Standards of Ethical Conduct
for Management Accountants” (described in Exhibit 1-7) that the management accountant should
consider are listed below.

Competence
Clear reports using relevant and reliable information should be prepared. Preparing reports on
the basis of incorrect costs in order to retain product lines violates competence standards. It is
unethical for Benzo to change the ABC system with the specific goal of reporting different
product cost numbers that Duval favors.

Integrity
The management accountant has a responsibility to avoid actual or apparent conflicts of interest
and advise all appropriate parties of any potential conflict. Benzo may be tempted to change the
product cost numbers to please Duval, the division president. This action, however, would
violate the responsibility for integrity. The Standards of Ethical Conduct require the management
accountant to communicate favorable as well as unfavorable information.

Credibility
The management accountant’s standards of ethical conduct require that information should be
fairly and objectively communicated and that all relevant information should be disclosed. From

Accounting 507 Managerial Accounting Winter 2009 56


a management accountant’s standpoint, adjusting the product cost numbers to make both the
Monarch and Regal lines look profitable would violate the standard of objectivity.
Benzo should indicate to Duval that the product cost calculations are, indeed, appropriate.
If Duval still insists on modifying the product cost numbers, Benzo should raise the matter with
one of Duval’s superiors. If, after taking all these steps, there is continued pressure to modify
product cost numbers, Benzo should consider resigning from the company, rather than engage in
unethical behavior.

CHAPTER 11
11-23 (10 min.) Selection of most profitable product.

Only Model 14 should be produced. The key to this problem is the relationship of manufacturing
overhead to each product. Note that it takes twice as long to produce Model 9; machine-hours for
Model 9 are twice that for Model 14. Management should choose the product mix that
maximizes operating income for a given production capacity (the scarce resource in this
situation). In this case, Model 14 will yield a $9.50 contribution to fixed costs per machine hour,
and Model 9 will yield $9.00:

Model 9 Model 14

Selling price $100.00 $70.00


Variable costs per unit (total cost – FMOH) 82.00 60.50
Contribution margin per unit $ 18.00 $ 9.50
Relative use of machine-hours per unit of product ÷ 2 ÷ 1
Contribution margin per machine hour $ 9.00 $ 9.50

11-28 (30 min.) Equipment upgrade versus replacement.

1. Based on the analysis in the table below, TechMech will be better off by $180,000 over
three years if it replaces the current equipment.
Over 3 years Difference
Comparing Relevant Costs of Upgrade and Upgrade Replace in favor of Replace
Replace Alternatives (1) (2) (3) = (1) – (2)
Cash operating costs
$140; $80 per desk �6,000 desks per yr. �3 yrs. $2,520,000 $1,440,000 $1,080,000
Current disposal price (600,000) 600,000
One time capital costs, written off periodically as
depreciation 2,700,000 4,200,000 (1,500,000)
Total relevant costs $5,220,000 $5,040,000 $ 180,000

Note that the book value of the current machine ($900,000) would either be written off as
depreciation over three years under the upgrade option, or, all at once in the current year under
the replace option. Its net effect would be the same in both alternatives: to increase costs by
$900,000 over three years, hence it is irrelevant in this analysis.

Accounting 507 Managerial Accounting Winter 2009 57


2. Suppose the capital expenditure to replace the equipment is $X. From requirement 1,
column (2), substituting for the one-time capital cost of replacement, the relevant cost of
replacing is $1,440,000 – $600,000 + $X. From column (1), the relevant cost of upgrading is
$5,220,000. We want to find X such that
$1,440,000 – $600,000 + $X < $5,220,000 (i.e., TechMech will favor replacing)
Solving the above inequality gives us X < $5,220,000 – $840,000 = $4,380,000.

TechMech would prefer to replace, rather than upgrade, if the replacement cost of the new
equipment does not exceed $4,380,000. Note that this result can also be obtained by taking the
original replacement cost of $4,200,000 and adding to it the $180,000 difference in favor of
replacement calculated in requirement 1.

3. Suppose the units produced and sold over 3 years equal y. Using data from requirement 1,
column (1), the relevant cost of upgrade would be $140y + $2,700,000, and from column (2), the
relevant cost of replacing the equipment would be $80y – $600,000 + $4,200,000. TechMech
would want to upgrade if

$140y + $2,700,000 < $80y – $600,000 + $4,200,000

$60y < $900,000

y < $900,000 �$60 = 15,000 units

or upgrade when y < 15,000 units (or 5,000 per year for 3 years) and replace when y > 15,000
units over 3 years.
When production and sales volume is low (less than 5,000 per year), the higher operating
costs under the upgrade option are more than offset by the savings in capital costs from
upgrading. When production and sales volume is high, the higher capital costs of replacement are
more than offset by the savings in operating costs in the replace option.

Accounting 507 Managerial Accounting Winter 2009 58


4. Operating income for the first year under the upgrade and replace alternatives are shown
below:
Year 1
Upgrade Replace
(1) (2)

Revenues (6,000 $500) $3,000,000 $3,000,000
Cash operating costs
$140; $80 per desk �6,000 desks per year 840,000 480,000
Depreciation ($900,000a + $2,700,000) �3; $4,200,000 �3 1,200,000 1,400,000
Loss on disposal of old equipment (0; $900,000 – $600,000) 0 300,000
Total costs 2,040,000 2,180,000
Operating Income $ 960,000 $ 820,000
a
The book value of the current production equipment is $1,500,000 �3 �5 = $900,000; it
has a remaining useful life of 3 years.

First-year operating income is higher by $140,000 under the upgrade alternative, and Dan Doria,
with his one-year horizon and operating income-based bonus, will choose the upgrade
alternative, even though, as seen in requirement 1, the replace alternative is better in the long run
for TechMech. This exercise illustrates the possible conflict between the decision model and the
performance evaluation model.

11-31 (30 min.) Relevant costs, opportunity costs.

1. Easyspread 2.0 has a higher relevant operating income than Easyspread 1.0. Based on this
analysis, Easyspread 2.0 should be introduced immediately:

Easyspread 1.0 Easyspread 2.0

Relevant revenues $160 $195

Relevant costs:

Manuals, diskettes, compact discs $ 0 $30

Total relevant costs 0 30

Relevant operating income $160 $165

Reasons for other cost items being irrelevant are:

Accounting 507 Managerial Accounting Winter 2009 59


Easyspread 1.0
 Manuals, diskettes—already incurred
 Development costs—already incurred
 Marketing and administrative—fixed costs of period

Easyspread 2.0
 Development costs—already incurred
 Marketing and administration—fixed costs of period

Note that total marketing and administration costs will not change whether Easyspread 2.0 is
introduced on July 1, 2009, or on October 1, 2009.

2 2. Other factors to be considered:


a. Customer satisfaction. If 2.0 is significantly better than 1.0 for its customers, a
customer driven organization would immediately introduce it unless other factors
offset this bias towards “do what is best for the customer.”
b. Quality level of Easyspread 2.0. It is critical for new software products to be fully
debugged. Easyspread 2.0 must be error-free. Consider an immediate release only if
2.0 passes all quality tests and can be fully supported by the salesforce.
c. Importance of being perceived to be a market leader. Being first in the market with a
new product can give Basil Software a “first-mover advantage,” e.g., capturing an
initial large share of the market that, in itself, causes future potential customers to
lean towards purchasing Easyspread 2.0. Moreover, by introducing 2.0 earlier, Basil
can get quick feedback from users about ways to further refine the software while its
competitors are still working on their own first versions. Moreover, by locking in
early customers, Basil may increase the likelihood of these customers also buying
future upgrades of Easyspread 2.0.
d. Morale of developers. These are key people at Basil Software. Delaying introduction
of a new product can hurt their morale, especially if a competitor then preempts Basil
from being viewed as a market leader.

Accounting 507 Managerial Accounting Winter 2009 60


11-34 (35–40 min.) Dropping a product line, selling more units.

1. The incremental revenue losses and incremental savings in cost by discontinuing the
Tables product line follows:
Difference:
Incremental
(Loss in Revenues)
and Savings in Costs
from Dropping
Tables Line
Revenues $(500,000)
Direct materials and direct manufacturing labor 300,000
Depreciation on equipment 0
Marketing and distribution 70,000
General administration 0
Corporate office costs 0
Total costs 370,000
Operating income (loss) $(130,000)

Dropping the Tables product line results in revenue losses of $500,000 and cost savings of
$370,000. Hence, Grossman Corporation’s operating income will be $130,000 lower if it
drops the Tables line.

Note that, by dropping the Tables product line, Home Furnishings will save none of the
depreciation on equipment, general administration costs, and corporate office costs, but it
will save variable manufacturing costs and all marketing and distribution costs on the
Tables product line.
2. Grossman’s will generate incremental operating income of $128,000 from selling 4,000
additional tables and, hence, should try to increase table sales. The calculations follow:
Incremental Revenues
(Costs) and Operating Income
Revenues $500,000
Direct materials and direct manufacturing labor (300,000)
Cost of equipment written off as depreciation (42,000)*
Marketing and distribution costs (30,000)†
General administration costs 0**
Corporate office costs 0**
Operating income $128,000
*
Note that the additional costs of equipment are relevant future costs for the “selling more tables decision” because
they represent incremental future costs that differ between the alternatives of selling and not selling additional
tables.

Current marketing and distribution costs which varies with number of shipments = $70,000 –
$40,000 = $30,000. As the sales of tables double, the number of shipments will double, resulting
in incremental marketing and distribution costs of (2  $30,000) – $30,000 = $30,000.
**
General administration and corporate office costs will be unaffected if Grossman decides to sell more tables.
Hence, these costs are irrelevant for the decision.

Accounting 507 Managerial Accounting Winter 2009 61


3.Solution Exhibit 11-34, Column 1, presents the relevant loss of revenues and the relevant
savings in costs from closing the Northern Division. As the calculations show, Grossman’s
operating income would decrease by $140,000 if it shut down the Northern Division (loss in
revenues of $1,500,000 versus savings in costs of $1,360,000).
Grossman will save variable manufacturing costs, marketing and distribution costs, and division
general administration costs by closing the Northern Division but equipment-related depreciation
and corporate office allocations are irrelevant to the decision. Equipment-related costs are
irrelevant because they are past costs (and the equipment has zero disposal price). Corporate
office costs are irrelevant because Grossman will not save any actual corporate office costs by
closing the Northern Division. The corporate office costs that used to be allocated to the
Northern Division will be allocated to other divisions.

4. Solution Exhibit 11-34, Column 2, presents the relevant revenues and relevant costs of
opening the Southern Division (a division whose revenues and costs are expected to be identical
to the revenues and costs of the Northern Division). Grossman should open the Southern
Division because it would increase operating income by $40,000 (increase in relevant revenues
of $1,500,000 and increase in relevant costs of $1,460,000). The relevant costs include direct
materials, direct manufacturing labor, marketing and distribution, equipment, and division
general administration costs but not corporate office costs. Note, in particular, that the cost of
equipment written off as depreciation is relevant because it is an expected future cost that
Grossman will incur only if it opens the Southern Division. Corporate office costs are irrelevant
because actual corporate office costs will not change if Grossman opens the Southern Division.
The current corporate staff will be able to oversee the Southern Division’s operations. Grossman
will allocate some corporate office costs to the Southern Division but this allocation represents
corporate office costs that are already currently being allocated to some other division. Because
actual total corporate office costs do not change, they are irrelevant to the division.
SOLUTION EXHIBIT 11-34
Relevant-Revenue and Relevant-Cost Analysis for Closing Northern Division and Opening
Southern Division

Incremental
(Loss in Revenues) Revenues and
and Savings in (Incremental Costs)
Costs from Closing from Opening
Northern Division Southern Division
(1) (2)
Revenues $(1,500,000) $1,500,000
Variable direct materials and direct
manufacturing labor costs 825,000 (825,000)
Equipment cost written off as depreciation 0 (100,000)
Marketing and distribution costs 205,000 (205,000)
Division general administration costs 330,000 (330,000)
Corporate office costs 0 0
Total costs 1,360,000 (1,460,000)
Effect on operating income (loss) $ (140,000) $ 40,000

Accounting 507 Managerial Accounting Winter 2009 62


11-35 (30–40 min.) Make or buy, unknown level of volume.

1. The variable costs required to manufacture 150,000 starter assemblies are

Direct materials $200,000


Direct manufacturing labor 150,000
Variable manufacturing overhead 100,000
Total variable costs $450,000

The variable costs per unit are $450,000 ÷ 150,000 = $3.00 per unit.

Let X = number of starter assemblies required in the next 12 months.

The data can be presented in both “all data” and “relevant data” formats:

All Data Relevant Data


Alternative Alternative Alternative Alternative
1: 2: 1: 2: Buy
Make Buy Make
Variable manufacturing costs $ 3X – $ 3X –
Fixed general manufacturing overhead 150,000 $150,000 – –
Fixed overhead, avoidable 100,000 – 100,000 –
Division 2 manager’s salary 40,000 50,000 40,000 $50,000
Division 3 manager’s salary 50,000 – 50,000 –
Purchase cost, if bought from
Tidnish Electronics – 4X – 4X
Total $340,000 $200,000 $190,000 $50,000
+ $ 3X + $ 4X + $ 3X + $ 4X

The number of units at which the costs of make and buy are equivalent is

All data analysis: $340,000 + $3X = $200,000 + $4X


X = 140,000
or
Relevant data analysis: $190,000 + $3X = $50,000 + $4X
X = 140,000
Assuming cost minimization is the objective, then
• If production is expected to be less than 140,000 units, it is preferable to buy units
from Tidnish.
• If production is expected to exceed 140,000 units, it is preferable to manufacture
internally (make) the units.
• If production is expected to be 140,000 units, Oxford should be indifferent between
buying units from Tidnish and manufacturing (making) the units internally.

Accounting 507 Managerial Accounting Winter 2009 63


2. The information on the storage cost, which is avoidable if self-manufacture is
discontinued, is relevant; these storage charges represent current outlays that are avoidable if
self-manufacture is discontinued. Assume these $50,000 charges are represented as an
opportunity cost of the make alternative. The costs of internal manufacture that incorporate this
$50,000 opportunity cost are

All data analysis: $390,000 + $3X


Relevant data analysis: $240,000 + $3X

The number of units at which the costs of make and buy are equivalent is

All data analysis: $390,000 + $3X = $200,000 + $4X


X = 190,000
Relevant data analysis: $240,000 + $3X = $50,000 + $4X
X = 190,000

If production is expected to be less than 190,000, it is preferable to buy units from Tidnish. If
production is expected to exceed 190,000, it is preferable to manufacture the units internally.

Accounting 507 Managerial Accounting Winter 2009 64


CHAPTER 7
7-18 (25–30 min.) Flexible-budget preparation and analysis.

1. Variance Analysis for Bank Management Printers for September 2009


Level 1 Analysis
Actual Static-Budget Static
Results Variances Budget
(1) (2) = (1) – (3) (3)
Units sold 12,000 3,000 U 15,000
a
Revenue $252,000 $ 48,000 U $300,000c
Variable costs 84,000d 36,000 F 120,000f
Contribution margin 168,000 12,000 U 180,000
Fixed costs 150,000 5,000 U 145,000
Operating income $ 18,000 $ 17,000 U $ 35,000

$17,000 U
Total static-budget variance
2. Level 2 Analysis

Flexible- Sales
Actual Budget Flexible Volume Static
Results Variances Budget Variances Budget
(1) (2) = (1) – (3) (3) (4) = (3) – (5) (5)
Units sold 12,000 0 12,000 3,000 U 15,000
Revenue $252,000a $12,000 F $240,000b $60,000 U $300,000c
Variable costs 84,000d 12,000 F 96,000e 24,000 F 120,000f
Contribution margin 168,000 24,000 F 144,000 36,000 U 180,000
Fixed costs 150,000 5,000 U 145,000 0 145,000
Operating income $ 18,000 $19,000 F $ (1,000) $36,000 U $ 35,000
$19,000 F $36,000 U
Total flexible-budget Total sales-volume
variance
$17,000 U
Total static-budget variance
a d
12,000 × $21 = $252,000 12,000 × $7 = $ 84,000
b e
12,000 × $20 = $240,000 12,000 × $8 = $ 96,000
c f
15,000 × $20 = $300,000 15,000 × $8 = $120,000

3. Level 2 analysis breaks down the static-budget variance into a flexible-budget variance
and a sales-volume variance. The primary reason for the static-budget variance being
unfavorable ($17,000 U) is the reduction in unit volume from the budgeted 15,000 to an actual
12,000. One explanation for this reduction is the increase in selling price from a budgeted $20 to
an actual $21. Operating management was able to reduce variable costs by $12,000 relative to
the flexible budget. This reduction could be a sign of efficient management. Alternatively, it
could be due to using lower quality materials (which in turn adversely affected unit volume).

Accounting 507 Managerial Accounting Winter 2009 65


7-19 (30 min.) Flexible budget, working backward.

1. Variance Analysis for The Clarkson Company for the year ended December 31, 2009
Flexible-
Actual Budget Flexible Sales-Volume Static
Results Variances Budget Variances Budget
(1) (2)=(1)(3) (3) (4)=(3)(5) (5)
Units sold 130,000 0 130,000 10,000 F 120,000
Revenues $715,000 $260,000 F $455,000a $35,000 F $420,000
Variable costs 515,000 255,000 U 260,000b 20,000 U 240,000
Contribution margin 200,000 5,000 F 195,000 15,000 F 180,000
Fixed costs 140,000 20,000 U 120,000 0 120,000
Operating income $ 60,000 $ 15,000 U $ 75,000 $15,000 F $ 60,000
$15,000 U $15,000 F
a
130,000 × $3.50 = $455,000; Total
$420,000 �120,000 variance
flexible-budget = $3.50 Total sales volume variance
b
130,000 × $2.00 = $260,000; $240,000 120,000 = $2.00 $0

Total static-budget variance
2. Actual selling price: $715,000  130,000 = $5.50
Budgeted selling price: 420,000 ÷ 120,000 = $3.50
Actual variable cost per unit: 515,000 ÷ 130,000 = $3.96
Budgeted variable cost per unit: 240,000 ÷ 120,000 = $2.00

3. A zero total static-budget variance may be due to offsetting total flexible-budget and total
sales-volume variances. In this case, these two variances exactly offset each other:

Total flexible-budget variance $15,000 Unfavorable


Total sales-volume variance $15,000 Favorable

A closer look at the variance components reveals some major deviations from plan.
Actual variable costs increased from $2.00 to $3.96, causing an unfavorable flexible-budget
variable cost variance of $255,000. Such an increase could be a result of, for example, a jump in
direct material prices. Clarkson was able to pass most of the increase in costs onto their
customers—actual selling price increased by 57% [($5.50 – $3.50) �$3.50], bringing about an
offsetting favorable flexible-budget revenue variance in the amount of $260,000. An increase in
the actual number of units sold also contributed to more favorable results. The company should
examine why the units sold increased despite an increase in direct material prices. For example,
Clarkson’s customers may have stocked up, anticipating future increases in direct material prices.
Alternatively, Clarkson’s selling price increases may have been lower than competitors’ price
increases. Understanding the reasons why actual results differ from budgeted amounts can help
Clarkson better manage its costs and pricing decisions in the future. The important lesson learned
here is that a superficial examination of summary level data (Levels 0 and 1) may be insufficient.
It is imperative to scrutinize data at a more detailed level (Level 2). Had Clarkson not been able
to pass costs on to customers, losses would have been considerable.

Accounting 507 Managerial Accounting Winter 2009 66


7-20 (30-40 min.) Flexible budget and sales volume variances.

1. and 2.
Performance Report for Marron, Inc., June 2009

Static Budget
Flexible Static Variance as
Budget Flexible Sales Volume Static Budget % of Static
Actual Variances Budget Variances Budget Variance Budget
(1) (2) = (1) – (3) (3) (4) = (3) – (5) (5) (6) = (1) – (5) (7) = (6) �(5)
Units (pounds) 525,000 - 525,000 25,000 F 500,000 25,000 F 5.0%
Revenues $3,360,000 $ 52,500 U $3,412,500a $162,500 F $3,250,000 $110,000 F 3.4%
Variable mfg. costs 1,890,000 52,500 U 1,837,500b 87,500 U 1,750,000 140,000 U 8.0%
Contribution margin $1,470,000 $105,000 U $1,575,000 $ 75,000 F $1,500,000 $ 30,000 U 2.0%

$105,000 U $ 75,000 F
Flexible-budget variance Sales-volume variance

$30,000 U
Static-budget variance
a
Budgeted selling price = $3,250,000 �500,000 lbs = $6.50 per lb.
Flexible-budget revenues = $6.50 per lb. �525,000 lbs. = $3,412,500
b
Budgeted variable mfg. cost per unit = $1,750,000 �500,000 lbs. = $3.50
Flexible-budget variable mfg. costs = $3.50 per lb. �525,000 lbs. = $1,837,500

Accounting 507 Managerial Accounting Winter 2009 67


3. The selling price variance, caused solely by the difference in actual and budgeted selling
price, is the flexible-budget variance in revenues = $52,500 U.

4. The flexible-budget variances show that for the actual sales volume of 525,000 pounds,
selling prices were lower and costs per pound were higher. The favorable sales volume variance
in revenues (because more pounds of ice cream were sold than budgeted) helped offset the
unfavorable variable cost variance and shored up the results in June 2009. Levine should be more
concerned because the small static-budget variance in contribution margin of $30,000 U is
actually made up of a favorable sales-volume variance in contribution margin of $75,000, an
unfavorable selling-price variance of $52,500 and an unfavorable variable manufacturing costs
variance of $52,500. Levine should analyze why each of these variances occurred and the
relationships among them. Could the efficiency of variable manufacturing costs be improved?
Did the sales volume increase because of a decrease in selling price or because of growth in the
overall market? Analysis of these questions would help Levine decide what actions he should
take.

7-23 (30 min.) Direct materials and direct manufacturing labor variances.

1.
Actual
Quantity �
Actual Price Budgeted Efficiency Flexible
May 2009 Results Variance Price Variance Budget
(1) (2) = (1)–(3) (3) (4) = (3) – (5) (5)
Units 550 550
Direct materials $12,705.00 $1,815.00 U $10,890.00a $990.00 U $9,900.00b
Direct labor $ 8,464.50 $ 104.50 U $ 8,360.00c $440.00 F $8,800.00d
Total price variance $1,919.50 U
Total efficiency variance $550.00 U

Accounting 507 Managerial Accounting Winter 2009 68


a
7,260 meters �$1.50 per meter = $10,890
b
550 lots �12 meters per lot �$1.50 per meter = $9,900
c
1,045 hours �$8.00 per hour = $8,360
d
550 lots �2 hours per lot �$8 per hour = $8,800

Total flexible-budget variance for both inputs = $1,919.50U + $550U = $2,469.50U


Total flexible-budget cost of direct materials and direct labor = $9,900 + $8,800 = $18,700
Total flexible-budget variance as % of total flexible-budget costs = $2,469.50 �$18,700 = 13.21%

2.
Actual
Quantity �
May Actual Price Budgeted Efficiency Flexible
2010 Results Variance Price Variance Budget
(1) (2) = (1) – (3) (3) (4) = (3) – (5) (5)
Units 550 550
Direct materials $11,828.36a $1,156.16 U $10,672.20b $772.20 U $9,900.00c
Direct manuf. labor $ 8,295.21d $ 102.41 U $ 8,192.80e $607.20 F $8,800.00c
Total price variance $1,258.57 U
Total efficiency variance $165.00 U
a
Actual dir. mat. cost, May 2010 = Actual dir. mat. cost, May 2009 �0.98 �0.95 = $12,705 �0.98 �
0.95 = $11.828.36
Alternatively, actual dir. mat. cost, May 2010
= (Actual dir. mat. quantity used in May 2009 �0.98) �(Actual dir. mat. price in May 2009 �
0.95)
= (7,260 meters �0.98) �($1.75/meter �0.95)
= 7,114.80 �$1.6625 = $11,828.36
b
(7,260 meters �0.98) �$1.50 per meter = $10,672.20
c
Unchanged from 2009.
d
Actual dir. labor cost, May 2010 = Actual dir. manuf. cost May 2009 �0.98 = $8,464.50 �0.98 =
$8,295.21
Alternatively, actual dir. labor cost, May 2010
= (Actual dir. manuf. labor quantity used in May 2009 �0.98) �Actual dir. labor price in 2009
= (1,045 hours �0.98) �$8.10 per hour
= 1,024.10 hours �$8.10 per hour = $8,295.21
e
(1,045 hours �0.98) �$8.00 per hour = $8,192.80

Total flexible-budget variance for both inputs = $1,258.57U + $165U = $1,423.57U


Total flexible-budget cost of direct materials and direct labor = $9,900 + $8,800 = $18,700

Total flexible-budget variance as % of total flexible-budget costs = $1,423.57 �$18,700 = 7.61%

3. Efficiencies have improved in the direction indicated by the production manager—but, it


is unclear whether they are a trend or a one-time occurrence. Also, overall, variances are still
7.6% of flexible input budget. GloriaDee should continue to use the new material, especially in
light of its superior quality and feel, but it may want to keep the following points in mind:

Accounting 507 Managerial Accounting Winter 2009 69


 The new material costs substantially more than the old ($1.75 in 2009 and $1.6625 in
2010 vs. $1.50 per meter). Its price is unlikely to come down even more within the
coming year. Standard material price should be re-examined and possibly changed.
 GloriaDee should continue to work to reduce direct materials and direct
manufacturing labor content. The reductions from May 2009 to May 2010 are a good
development and should be encouraged.

Accounting 507 Managerial Accounting Winter 2009 70


7-39 (60 min.) Comprehensive variance analysis review.

Actual Results
Units sold (90% × 2,000,000) 1,800,000
Selling price per unit $4.80
Revenues (1,800,000 × $4.80) $8,640,000
Direct materials purchased and used:
Direct materials per unit $0.80
Total direct materials cost (1,800,000 × $0.80) $1,440,000
Direct manufacturing labor:
Actual manufacturing rate per hour $15
Labor productivity per hour in units 250
Manufacturing labor-hours of input (1,800,000 ÷ 250) 7,200
Total direct manufacturing labor costs (7,200 × $15) $108,000
Direct marketing costs:
Direct marketing cost per unit $0.30
Total direct marketing costs (1,800,000 × $0.30) $540,000
Fixed costs ($850,000  $30,000) $820,000

Static Budgeted Amounts


Units sold 2,000,000
Selling price per unit $5.00
Revenues (2,000,000 × $5.00) $10,000,000
Direct materials purchased and used:
Direct materials per unit $0.85
Total direct materials costs (2,000,000 × $0.85) $1,700,000
Direct manufacturing labor:
Direct manufacturing rate per hour $15.00
Labor productivity per hour in units 300
Manufacturing labor-hours of input (2,000,000 ÷ 300) 6,667
Total direct manufacturing labor cost (6,667 × $15.00) $100,000
Direct marketing costs:
Direct marketing cost per unit $0.30
Total direct marketing cost (2,000,000 × $0.30) $600,000
Fixed costs $850,000

1. Actual Static-Budget
Results Amounts
Revenues $8,640,000 $10,000,000
Variable costs
Direct materials 1,440,000 1,700,000
Direct manufacturing labor 108,000 100,000
Direct marketing costs 540,000 600,000
Total variable costs 2,088,000 2,400,000
Contribution margin 6,552,000 7,600,000
Fixed costs 820,000 850,000
Operating income $5,732,000 $6,750,000
2. Actual operating income $5,732,000
Static-budget operating income 6,750,000
Total static-budget variance $1,018,000 U

Accounting 507 Managerial Accounting Winter 2009 71


Flexible-budget-based variance analysis for Sonnet, Inc. for March 2010:

Actual Flexible-Budget Flexible Sales-Volume Static


Results Variances Budget Variances Budget

Units (diskettes) sold 1,800,000 0 1,800,000 200,000 2,000,000

Revenues $8,640,000 $360,000 U $9,000,000 $1,000,000 U $10,000,000


Variable costs
Direct materials 1,440,000 90,000 F 1,530,000 170,000 F 1,700,000
Direct manuf. labor 108,000 18,000 U 90,000 10,000 F 100,000
Direct marketing costs 540,000 0 540,000 60,000 F 600,000
Total variable costs 2,088,000 72,000 F 2,160,000 240,000 F 2,400,000
Contribution margin 6,552,000 288,000 U 6,840,000 760,000 U 7,600,000
Fixed costs 820,000 30,000 F 850,000 0 850,000

Operating income $5,732,000 $258,000 U $5,990,000 $ 760,000 U $6,750,000


$1,018,000 U

Total static-budget variance

$258,000 U $760,000 U

Total flexible-budget Total sales-volume


variance variance

3. Flexible-budget operating income = $5,990,000.


4. Flexible-budget variance for operating income = $258,000U.
5. Sales-volume variance for operating income = $760,000U.

Analysis of direct mfg. labor flexible-budget variance for Sonnet, Inc. for March 2010
Flexible Budget
Actual Costs (Budgeted Input
Incurred Qty. Allowed for
(Actual Input Qty. Actual Input Qty. Actual Output
× Actual Price) × Budgeted Price × Budgeted Price)
Direct. (7,200 × $15.00) (7,200 × $15.00) (*6,000 × $15.00)
Mfg. Labor $108,000 $108,000 $90,000

$0 $18,000 U
Price variance Efficiency variance
$18,000 U
Flexible-budget variance

* 1,800,000 units ÷ 300 direct manufacturing labor standard productivity rate per hour.
6. DML price variance = $0; DML efficiency variance = $18,000U
7. DML flexible-budget variance = $18,000U

Accounting 507 Managerial Accounting Winter 2009 72


CHAPTER 8

8-16 (20 min.) Variable manufacturing overhead, variance analysis.

1. Variable Manufacturing Overhead Variance Analysis for Esquire Clothing for June 2009
Flexible Budget: Allocated:
Actual Costs Budgeted Input Qty. Budgeted Input Qty.
Incurred Allowed for Allowed for
Actual Input Qty. Actual Input Qty. Actual Output Actual Output
× Actual Rate × Budgeted Rate × Budgeted Rate × Budgeted Rate
(1) (2) (3) (4)
(4,536 × $11.50) (4,536 × $12) (4 × 1,080 × $12) (4 × 1,080 × $12)
$52,164 $54,432 $51,840 $51,840

$2,268 F $2,592 U
Spending variance Efficiency variance Never a variance

$324 U
Flexible-budget variance Never a variance

2. Esquire had a favorable spending variance of $2,268 because the actual variable overhead
rate was $11.50 per direct manufacturing labor-hour versus $12 budgeted. It had an unfavorable
efficiency variance of $2,592 U because each suit averaged 4.2 labor-hours (4,536 hours ÷ 1,080
suits) versus 4.0 budgeted labor-hours.

Accounting 507 Managerial Accounting Winter 2009 73


8-17 (20 min.) Fixed-manufacturing overhead, variance analysis (continuation of 8-16).

Budgeted fixed overhead $62,400


1 & 2. rate per unit of = 1,040  4
allocation base
$62,400
= 4,160
= $15 per hour

Fixed Manufacturing Overhead Variance Analysis for Esquire Clothing for June 2009

Flexible Budget:
Same Budgeted Same Budgeted Allocated:
Lump Sum Lump Sum Budgeted Input Qty.
(as in Static Budget) (as in Static Budget) Allowed for Actual
Actual Costs Regardless of Regardless of Output
Incurred Output Level Output Level × Budgeted Rate
(1) (2) (3) (4)
(4 × 1,080 × $15)
$63,916 $62,400 $62,400 $64,800

$1,516 U $2,400 F
Spending variance Never a variance Production-volume variance

$1,516 U $2,400 F
Flexible-budget variance Production-volume variance

The fixed manufacturing overhead spending variance and the fixed manufacturing
flexible budget variance are the same––$1,516 U. Esquire spent $1,516 above the $62,400
budgeted amount for June 2009.
The production-volume variance is $2,400 F. This arises because Esquire utilized its
capacity more intensively than budgeted (the actual production of 1,080 suits exceeds the
budgeted 1,040 suits). This results in overallocated fixed manufacturing overhead of $2,400 (4 ×
40 × $15). Esquire would want to understand the reasons for a favorable production-volume
variance. Is the market growing? Is Esquire gaining market share? Will Esquire need to add
capacity?

Accounting 507 Managerial Accounting Winter 2009 74


8-21 (1015 min.) 4-variance analysis, fill in the blanks.

Variable Fixed
1. Spending variance $4,200 U $3,000 U
2. Efficiency variance 4,500 U NEVER
3. Production-volume variance NEVER 600 U
4. Flexible-budget variance 8,700 U 3,000 U
5. Underallocated (overallocated) MOH 8,700 U 3,600 U

These relationships could be presented in the same way as in Exhibit 8-4.

Flexible Budget: Allocated:


Budgeted Input Qty. Budgeted Input Qty.
Allowed for Allowed for
Actual Costs Actual Input Qty. Actual Output Actual Output
Incurred × Budgeted Rate × Budgeted Rate × Budgeted Rate
(1) (2) (3) (4)
Variable $35,700 $31,500 $27,000 $27,000
MOH

$4,200 U $4,500 U
Spending variance Efficiency variance Never a variance

$8,700 U
Flexible-budget variance Never a variance
$8,700 U
Underallocated variable overhead
(Total variable overhead variance)

Flexible Budget:
Same Budgeted Same Budgeted Allocated:
Lump Sum Lump Sum Budgeted Input Qty.
(as in Static Budget) (as in Static Budget) Allowed for
Actual Costs Regardless of Regardless of Actual Output
Incurred Output Level Output Level × Budgeted Rate
(1) (2) (3) (4)
Fixed $18,000 $15,000 $15,000 $14,400
MOH
$3,000 U $600 U
Spending variance Never a variance Production-volume variance

$3,000 U $600 U
Flexible-budget variance Production-volume variance

$3,600 U
Underallocated fixed overhead
(Total fixed overhead variance)
Accounting 507 Managerial Accounting Winter 2009 75
An overview of the 4 overhead variances is:

Production-Volume
4-Variance Spending Efficiency Variance
Analysis Variance Variance
Variable
Overhead $4,200 U $4,500 U Never a variance
Fixed
Overhead $3,000 U Never a variance $600 U

Accounting 507 Managerial Accounting Winter 2009 76


8-27 (15 min.) Identifying favorable and unfavorable variances.

VOH  VOH  FOH  FOH 


Spending Efficiency  Spending Production­
Scenario Variance Variance Variance Volume Variance
Production output is  Cannot be  Cannot be  Unfavorable:  Favorable: output 
5% more than  determined: no  determined: no  actual fixed  is more than 
budgeted, and actual  information on  information on  costs are more  budgeted causing 
fixed manufacturing  actual versus  actual versus  than budgeted  FOH costs to be 
overhead costs are 6%  budgeted VOH  flexible­budget  fixed costs overallocated
more than budgeted rates machine­hours

Production output is  Cannot be  Favorable: actual  Cannot be  Favorable: output 


10% more than  determined: no  machine­hours less  determined:  no  is more than 
budgeted; actual  information on  than flexible­ information on  budgeted causing 
machine hours are 5%  actual versus  budget machine­ actual versus  FOH costs to be 
less than budgeted budgeted VOH  hours budgeted FOH  overallocated
rates costs
Production output is  Cannot be  Cannot be  Cannot be  Unfavorable: 
8% less than budgeted determined: no  determined: no  determined: no  output less than 
information on  information on  information on  budgeted will 
actual versus  actual machine­ actual versus  cause FOH costs to
budgeted VOH  hours versus  budgeted FOH  be underallocated
rates flexible­budget  costs
machine­hours
Actual machine hours  Cannot be  Unfavorable: more  Cannot be  Cannot be 
are 15% greater than  determined: no  machine­hours  determined: no  determined: no 
flexible­budget  information on  used relative to  information on  information on 
machine hours actual versus  flexible budget actual versus  flexible­budget 
budgeted VOH  budgeted FOH  machine­hours 
rates costs relative to static­
budget machine­
hours
Relative to the flexible  Unfavorable:  Unfavorable: actual Cannot be  Cannot be 
budget, actual machine  actual VOH rate  machine­hours  determined: no  determined: no 
hours are 10% greater  greater than  greater than  information on  information on 
and actual variable  budgeted VOH  flexible­budget  actual versus  actual output 
manufacturing  rate machine­hours budgeted FOH  relative to 
overhead costs are 15% costs budgeted output
greater

Accounting 507 Managerial Accounting Winter 2009 77


8-29 (30 min.) Comprehensive variance analysis.

1. Budgeted number of machine-hours planned can be calculated by multiplying the number


of units planned (budgeted) by the number of machine-hours allocated per unit:

888 units  2 machine-hours per unit = 1,776 machine-hours.

2. Budgeted fixed MOH costs per machine-hour can be computed by dividing the flexible
budget amount for fixed MOH (which is the same as the static budget) by the number of
machine-hours planned (calculated in (a.)):
$348,096 ÷ 1,776 machine-hours = $196.00 per machine-hour

3. Budgeted variable MOH costs per machine-hour are calculated as budgeted variable
MOH costs divided by the budgeted number of machine-hours planned:
$71,040 ÷ 1,776 machine-hours = $40.00 per machine-hour.

4. Budgeted number of machine-hours allowed for actual output achieved can be calculated
by dividing the flexible-budget amount for variable MOH by budgeted variable MOH
costs per machine-hour:
$76,800 ÷ $40.00 per machine-hour= 1,920 machine-hours allowed

5. The actual number of output units is the budgeted number of machine-hours allowed for
actual output achieved divided by the planned allocation rate of machine hours per unit:
1,920 machine-hours ÷ 2 machine-hours per unit = 960 units.

6. The actual number of machine-hours used per output unit is the actual number of
machine hours used (given) divided by the actual number of units manufactured:
1,824 machine-hours ÷ 960 units = 1.9 machine-hours used per output unit.

Accounting 507 Managerial Accounting Winter 2009 78


8-39 (3040 min.) Comprehensive review of Chapters 7 and 8, working backward from
given variances.

1. Solution Exhibit 8-39 outlines the Chapter 7 and 8 framework underlying this solution.

a. Pounds of direct materials purchased = $176,000 ÷ $1.10 = 160,000 pounds

b. Pounds of excess direct materials used = $69,000 ÷ $11.50 = 6,000 pounds

c. Variable manufacturing overhead spending variance = $10,350 – $18,000 = $7,650 F

d. Standard direct manufacturing labor rate = $800,000 ÷ 40,000 hours = $20 per hour
Actual direct manufacturing labor rate = $20 + $0.50 = $20.50
Actual direct manufacturing labor-hours = $522,750 ÷ $20.50
= 25,500 hours

e. Standard variable manufacturing overhead rate = $480,000 ÷ 40,000


= $12 per direct manuf. labor-hour
Variable manuf. overhead efficiency variance of $18,000 ÷ $12 = 1,500 excess hours
Actual hours – Excess hours = Standard hours allowed for units produced
25,500 – 1,500 = 24,000 hours

f. Budgeted fixed manufacturing overhead rate = $640,000 ÷ 40,000 hours


= $16 per direct manuf. labor-hour
Fixed manufacturing overhead allocated = $16  24,000 hours = $384,000
Production-volume variance = $640,000 – $384,000 = $256,000 U

1. The control of variable manufacturing overhead requires the identification of the cost drivers
for such items as energy, supplies, and repairs. Control often entails monitoring nonfinancial
measures that affect each cost item, one by one. Examples are kilowatts used, quantities of
lubricants used, and repair parts and hours used. The most convincing way to discover why
overhead performance did not agree with a budget is to investigate possible causes, line item by
line item.
Individual fixed overhead items are not usually affected very much by day-to-day control.
Instead, they are controlled periodically through planning decisions and budgeting procedures
that may sometimes have planning horizons covering six months or a year (for example,
management salaries) and sometimes covering many years (for example, long-term leases and
depreciation on plant and equipment).

Accounting 507 Managerial Accounting Winter 2009 79


Solution Exhibit 8-39

Flexible Budget:
Actual Costs Budgeted Input Qty.
Incurred Actual Input Qty. Allowed for
(Actual Input Qty.  Budgeted Rate Actual Output
 Actual Rate) Purchases Usage  Budgeted Rate
Direct 160,000  $10.40 160,000  $11.50 96,000  $11.50 3  30,000  $11.50
Materials $1,664,000 $1,840,000 $1,104,000 $1,035,000
$176,000 F $69,000 U
Price variance Efficiency variance

Direct 0.85  30,000  $20.50 0.85  30,000  $20 0.80  30,000  $20
Manuf. $522,750 $510,000 $480,000
Labor
$12,750 U $30,000 U
Price variance Efficiency variance
$42,750 U
Flexible-budget variance
Flexible Budget: Allocated:
Actual Costs Budgeted Input Qty. Budgeted Input Qty.
Incurred Allowed for Allowed for
Actual Input Qty. Actual Input Qty. Actual Output Actual Output
 Actual Rate  Budgeted Rate  Budgeted Rate  Budgeted Rate
Variable 0.85  30,000  $11.70 0.85  30,000  $12 0.80  30,000  $12 0.80  30,000  $12
MOH $298,350 $306,000 $288,000 $288,000
$7,650 F $18,000 U
Spending variance Efficiency Never a variance
$10,350 U variance
Flexible-budget variance Never a variance

Flexible Budget:
Same Budgeted Same Budgeted Allocated:
Lump Sum Lump Sum Budgeted Input Qty.
(as in Static Budget) (as in Static Budget) Allowed for
Actual Costs Regardless of Regardless of Actual Output
Incurred Output Level Output Level × Budgeted Rate
(1) (2) (3) (4)
Fixed 0.80 × 50,000 × $16 0.80 x 30,000 × $16
MOH $597,460 $640,000 $640,000 $384,000

$42,540 F $256,000 U
Spending variance Never a variance
volume variance $42,540 F $256,000 U
Flexible-budget variance Production volume variance

Accounting 507 Managerial Accounting Winter 2009 80


CHAPTER 22
22-21 (30 min.) Effect of alternative transfer-pricing methods on division operating income.

Method A Method B
Internal Transfers Internal Transfers at
at Market Prices 110% of Full Costs
1. Mining Division
Revenues:
$90, $661  200,000 units $18,000,000 $13,200,000
Costs:
Division variable costs:
$522  200,000 units 10,400,000 10,400,000
Division fixed costs:
$83  200,000 units 1,600,000 1,600,000
Total division costs 12,000,000 12,000,000
Division operating income $ 6,000,000 $ 1,200,000
Metals Division
Revenues:
$150  200,000 units $30,000,000 $30,000,000
Costs:
Transferred-in costs:
$90, $66  200,000 units 18,000,000 13,200,000
Division variable costs:
$364  200,000 units 7,200,000 7,200,000
Division fixed costs:
$155  200,000 units 3,000,000 3,000,000
Total division costs 28,200,000 23,400,000
Division operating income $ 1,800,000 $ 6,600,000

1
$66 = Full manufacturing cost per unit in the Mining Division, $60  110%
2
Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labor +
75% of manufacturing overhead = $12 + $16 + (75%  $32) = $52
3
Fixed cost per unit = 25% of manufacturing overhead = 25%  $32 = $8
4
Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40%
of manufacturing overhead = $6 + $20 + (40%  $25) = $36
5
Fixed cost per unit in Metals Division = 60% of manufacturing overhead = 60%  $25 = $15

Accounting 507 Managerial Accounting Winter 2009 81


2. Bonus paid to division managers at 1% of division operating income will be as follows:

Method A Method B
Internal Transfers Internal Transfers at
at Market Prices 110% of Full Costs
Mining Division manager’s bonus
(1%  $6,000,000; 1%  $1,200,000) $60,000 $ 12,000
Metals Division manager’s bonus
(1%  $1,800,000; 1%  $6,600,000) 18,000 66,000

The Mining Division manager will prefer Method A (transfer at market prices) because
this method gives $60,000 of bonus rather than $12,000 under Method B (transfers at 110% of
full costs). The Metals Division manager will prefer Method B because this method gives
$66,000 of bonus rather than $18,000 under Method A.

3. Brian Jones, the manager of the Mining Division, will appeal to the existence of a
competitive market to price transfers at market prices. Using market prices for transfers in these
conditions leads to goal congruence. Division managers acting in their own best interests make
decisions that are also in the best interests of the company as a whole.
Jones will further argue that setting transfer prices based on cost will cause Jones to pay
no attention to controlling costs since all costs incurred will be recovered from the Metals
Division at 110% of full costs.

22-22 (30 min.) Transfer pricing, general guideline, goal congruence.

1. Using the general guideline presented in the chapter, the minimum price at which the
Airbag Division would sell airbags to the Tivo Division is $90, the incremental costs. The Airbag
Division has idle capacity (it is currently working at 80% of capacity). Therefore, its opportunity
cost is zero—the Airbag Division does not forgo any external sales and as a result, does not forgo
any contribution margin from internal transfers. Transferring airbags at incremental cost achieves
goal congruence.

2. Transferring products internally at incremental cost has the following properties:

a. Achieves goal congruence—Yes, as described in requirement 1 above.


b. Useful for evaluating division performance—No, because this transfer price does not
cover or exceed full costs. By transferring at incremental costs and not covering fixed
costs, the Airbag Division will show a loss. This loss, the result of the incremental
cost-based transfer price, is not a good measure of the economic performance of the
subunit.
c. Motivating management effort—Yes, if based on budgeted costs (actual costs can
then be compared to budgeted costs). If, however, transfers are based on actual costs,
Airbag Division management has little incentive to control costs.
d. Preserves division autonomy—No. Because it is rule-based, the Airbag Division has
no say in the setting of the transfer price.

Accounting 507 Managerial Accounting Winter 2009 82


3. If the two divisions were to negotiate a transfer price, the range of possible transfer prices
will be between $90 and $125 per unit. The Airbag Division has excess capacity that it can use to
supply airbags to the Tivo Division. The Airbag Division will be willing to supply the airbags
only if the transfer price equals or exceeds $90, its incremental costs of manufacturing the
airbags. The Tivo Division will be willing to buy airbags from the Airbag Division only if the
price does not exceed $125 per airbag, the price at which the Tivo division can buy airbags in the
market from external suppliers. Within the price range or $90 and $125, each division will be
willing to transact with the other and maximize overall income of Quest Motors. The exact
transfer price between $90 and $125 will depend on the bargaining strengths of the two
divisions. The negotiated transfer price has the following properties.

a. Achieves goal congruence—Yes, as described above.


b. Useful for evaluating division performance—Yes, because the transfer price is the
result of direct negotiations between the two divisions. Of course, the transfer prices
will be affected by the bargaining strengths of the two divisions.
c. Motivating management effort—Yes, because once negotiated, the transfer price is
independent of actual costs of the Airbag Division. Airbag Division management has
every incentive to manage efficiently to improve profits.
d. Preserves subunit autonomy—Yes, because the transfer price is based on direct
negotiations between the two divisions and is not specified by headquarters on the
basis of some rule (such as Airbag Division’s incremental costs).

4. Neither method is perfect, but negotiated transfer pricing (requirement 3) has more
favorable properties than the cost-based transfer pricing (requirement 2). Both transfer-pricing
methods achieve goal congruence, but negotiated transfer pricing facilitates the evaluation of
division performance, motivates management effort, and preserves division autonomy, whereas
the transfer price based on incremental costs does not achieve these objectives.

Accounting 507 Managerial Accounting Winter 2009 83


22-27 (20min.) General guideline, transfer pricing.

1. The minimum transfer price that the SD would demand from the AD is the net price it
could obtain from selling its screens on the outside market: $120 minus $5 marketing and
distribution cost per screen, or $115 per screen. The SD is operating at capacity. The incremental
cost of manufacturing each screen is $80. Therefore, the opportunity cost of selling a screen to
the AD is the contribution margin the SD would forego by transferring the screen internally
instead of selling it on the outside market.

Contribution margin per screen = $115 – $80 = $35

Using the general guideline,

Minimum transfer Incremental cost per Opportunity cost per


price per screen = screen inccurred up to + screen to the
the point of transfer selling division

= $80 + $35 = $115

2. The maximum transfer price the AD manager would be willing to offer SD is its own
total cost for purchasing from outside, $120 plus $3 per screen, or $123 per screen.

3a. If the SD has excess capacity (relative to what the outside market can absorb), the
minimum transfer price using the general guideline is: for the first 2,000 units (or 20% of
output), $80 per screen because opportunity cost is zero; for the remaining 8,000 units (or 80%
of output), $115 per screen because opportunity cost is $35 per screen.

3b. From the point of view of Shamrock’s management, all of the SD’s output should be
transferred to the AD. This would avoid the $3 per screen variable purchasing cost that is
incurred by the AD when it purchases screens from the outside market and it would also save the
$5 marketing and distribution cost the SD would incur to sell each screen to the outside market.

3c. If the managers of the AD and the SD could negotiate the transfer price, they would settle
on a price between $115 per screen (the minimum transfer price the SD will accept) and $123 per
screen (the maximum transfer price the AD would be willing to pay). From requirements 1 and 2,
we see that any price in this range would be acceptable to both divisions for all of the SD’s
output, and would also be optimal from Shamrock’s point of view. The exact transfer price
between $115 and $123 will depend on the bargaining strengths of the two divisions. Of course,
Shamrock's management could also mandate a particular transfer price between $115 and $123
per screen.

Accounting 507 Managerial Accounting Winter 2009 84


22-32 (40 min.) Multinational transfer pricing, global tax minimization.

This is a two-country two-division transfer-pricing problem with two alternative transfer-pricing


methods.

Summary data in U.S. dollars are:

South Africa Mining Division


Variable costs: 560 ZAR ÷ 7 = $80 per lb. of raw diamonds
Fixed costs: 1,540 ZAR ÷ 7 = $220 per lb. of raw diamonds
Market price: 3,150 ZAR ÷ 7 = $450 per lb. of raw diamonds

U.S. Processing Division


Variable costs = $150 per lb. of polished industrial diamonds
Fixed costs = $700 per lb. of polished industrial diamonds
Market price = $5,000 per lb. of polished industrial diamonds

1. The transfer prices are:


a. 200% of full costs
Mining Division to Processing Division
= 2.0 × ($80 + $220) = $600 per lb. of raw diamonds
b. Market price
Mining Division to Processing Division
= $450 per lb. of raw diamonds

200% of Market
Full Cost Price
South Africa Mining Division
Division revenues,  $600, $450  � 4,000 $2,400,000 $1,800,000
Costs
   Division variable costs,  $80  � 4,000 320,000 320,000
   Division fixed costs,  $220  � 4,000        880,000        880,000
      Total division costs   1,200,000
     1,200,000
  
Division operating income $1,200,000 $   600,000

U.S. Processing Division
Division revenues,  $5,000  � 2,000 $10,000,000 $10,000,000
Costs
   Transferred­in costs,  $600, $450  � 4,000 2,400,000 1,800,000
   Division variable cost,  $150  �2,000 300,000 300,000
   Division fixed costs,  $700  � 2,000      1,400,000       1,400,000
      Total division costs      4,100,000       3,500,000
Division operating income $ 5,900,000 $  6,500,000

Accounting 507 Managerial Accounting Winter 2009 85


Accounting 507 Managerial Accounting Winter 2009 86
2. 200% of Market
Full Cost Price
South Africa Mining Division
Division operating income $1,200,000 $600,000
Income tax at 18% 216,000 108,000
Division after-tax operating income $ 984,000 $492,000

U.S. Processing Division


Division operating income $5,900,000 $6,500,000
Income tax at 30% 1,770,000 1,950,000
Division after-tax operating income $4,130,000 $4,550,000

3. 200% of Market
Full Cost Price
South Africa Mining Division:
After-tax operating income $ 984,000 $ 492,000
U.S. Processing Division:
After-tax operating income 4,130,000 4,550,000
Industrial Diamonds:
After-tax operating income $5,114,000 $5,042,000

The South Africa Mining Division manager will prefer the higher transfer price of 200% of full
cost and the U.S. Processing Division manager will prefer the lower transfer price equal to
market price. Industrial Diamonds will maximize companywide net income by using the 200%
of full cost transfer-pricing method. This method sources more of the total income in South
Africa, the country with the lower income tax rate.

4. Factors that executives consider important in transfer pricing decisions include:


a. Performance evaluation
b. Management motivation
c. Pricing and product emphasis
d. External market recognition

Factors specifically related to multinational transfer pricing include:


a. Overall income of the company
b. Income or dividend repatriation restrictions
c. Competitive position of subsidiaries in their respective markets

Accounting 507 Managerial Accounting Winter 2009 87


22-34 (30 min.) Transfer pricing, goal congruence.

1. See column (1) of Solution Exhibit 22-34. The net cost of the in-house option is $230,000.

2. See columns (2a) and (2b) of Solution Exhibit 22-34. As the calculations show, if
Johnson Corporation offers a price of $38 per tape player, Orsilo Corporation should purchase
the tape players from Johnson; this will result in an incremental net cost of $210,000 (column
2a). If Johnson Corporation offers a price of $45 per tape player, Orsilo Corporation should
manufacture the tape players in-house; this will result in an incremental net cost of $230,000
(column 2b).

SOLUTION EXHIBIT 22-34


Transfer 10,000 Buy 10,000 tape Buy 10,000 tape Buy 10,000 tape
tape players to players from players from players from
Assembly. Sell Johnson at $38. Johnson at $40. Johnson at $45.
2,000 in outside Sell 12,000 tape Sell 12,000 tape Sell 12,000 tape
market at $35 players in outside players in players in
each market at $35 outside market
outside market at
each at $35 each
$35 each
(2a) (2x)
(1) (2b)
Incremental cost of Cassette
Division supplying 10,000 tape
players to Assembly Division
$25  10,000; 0; 0; 0
$(250,000) $ 0 $ 0 $ 0
Incremental costs of buying 10,000
tape players from Johnson
$0; $38  10,000; $40  10,000;
0 (380,000) (400,000) (450,000)
$45  10,000
Revenue from selling tape players in
outside market $35  2,000;
12,000; 12,000; 12,000
70,000 420,000 420,000 420,000

Incremental costs of manufacturing


tape players for sale in outside
market $25  2,000; 12,000;
12,000; 12,000
(50,000) (300,000) (300,000) (300,000)

Revenue from supplying head


mechanism to Johnson

Accounting 507 Managerial Accounting Winter 2009 88


$20  0; 10,000; 10,000; 10,000 0 200,000 200,000 200,000

Incremental costs of supplying head


mechanism to Johnson

$15  0; 10,000; 10,000; 10,000


0 (150,000) (150,000) (150,000)

Net costs $(230,000) $(210,000) $(230,000) $(280,000)

Comparing columns (1) and (2a), at a price of $38 per tape player from Johnson, the net
cost of $210,000 is less than the net cost of $230,000 to Orsilo Corporation if it made the tape
players in-house. So, Orsilo Corporation should outsource to Johnson.
Comparing columns (1) and (2b), at a price of $45 per tape player from Johnson, the net
cost of $280,000 is greater than the net cost of $230,000 to Orsilo Corporation if it made the tape
players in-house. Therefore, Orsilo Corporation should reject Johnson’s offer.
Now consider column (2x) of Solution Exhibit 22-34. It shows that at a price of $40 per
tape player from Johnson, the net cost is exactly $230,000, the same as the net cost to Orsilo
Corporation of manufacturing in-house (column 1). Thus, for prices between $38 and $40, Orsilo
will prefer to purchase from Johnson. For prices greater than $40 (and up to $45), Orsilo will
prefer to manufacture in-house.

3. The Cassette Division can manufacture at most 12,000 tape players and it is currently
operating at capacity. The incremental costs of manufacturing a tape player are $25 per unit. The
opportunity cost of manufacturing tape players for the Assembly Division is (1) the contribution
margin of $10 (selling price, $35 minus incremental costs $25) that the Cassette Division would
forgo by not selling tape players in the outside market plus (2) the contribution margin of $5
(selling price, $20 minus incremental costs, $15) that the Cassette Division would forgo by not
being able to sell the head mechanism to external suppliers of tape players such as Johnson
(recall that the Cassette division can produce as many head mechanisms as demanded by external
suppliers, but their demand will fall if the Cassette Division supplies the Assembly Division with
tape players). Thus, the total opportunity cost to the Cassette Division of supplying tape players
to Assembly is $10 + $5 = $15 per unit.

Using the general guideline,

Incremental cost per Opportunity cost per


Minimum transfer tape player up to the  tape player to the
price per tape player =
point of transfer selling division

= $25 + $15 = $40

Accounting 507 Managerial Accounting Winter 2009 89


Thus, the minimum transfer price that the Cassette Division will accept for each tape player is
$40. Note that at a price of $40, Orsilo is indifferent between manufacturing tape players in-
house or purchasing them from an external supplier.

4a. The transfer price is set to $40 + $1 = $41 and Johnson is offering the tape players for
$40.50 each. Now, for an outside price per tape player below $41, the Assembly Division would
prefer to purchase from outside; above it, the Assembly Division would prefer to purchase from
the Cassette Division. So, the Assembly division will buy from Johnson at $40.50 each and the
Cassette Division will be forced to sell its output on the outside market.

4b. But for Orsilo, as seen from requirements 1 and 2, an outside price of $40.50, which is
greater than the $40 cut-off price, makes inhouse manufacture the optimal choice. So, a
mandated transfer price of $41 causes the division managers to make choices that are sub-
optimal for Orsilo.

4c. When selling prices are uncertain, the transfer price should be set at the minimum
acceptable transfer price. It is only if the price charged by the external supplier falls below $40
that Orsilo Corporation as a whole is better off purchasing from the outside market. Setting the
transfer price at $40 per unit achieves goal congruence. The Cassette division will be willing to
sell to the Assembly Division, and the Assembly Division will be willing to buy in-house and
this would be optimal for Orsilo, too.

Accounting 507 Managerial Accounting Winter 2009 90